Understanding Interest Rates and the Fed, Part 1

When people talk about interest rates and investing, I find that there is often some confusion about what drives rates and the impact of the interest rate ecosystem as a whole. Most of the time when the topic of interest rates comes up, people will ask me, “When is the Fed going to raise rates? I need my bonds to pay a higher yield.” This is the primary example of the misunderstanding the public generally has about rates.

The Federal Reserve does not directly control the bond market. The Fed controls monetary policy, primarily through setting the Fed Funds target rate. This is the rate that banks charge each other for bank-to-bank, unsecured lending, typically overnight. While there is some correlation, the Fed does not control rates in the bond market. Bond interest rates are set by the market, supply and demand. Supply and demand in the bond market is determined by investors expectations about the future of the economy, expected inflation, and the borrowers ability to pay back the debt, among other things. Typically, investors behave based on expectations rather than reacting to things after they’ve happened. The bond interest rate market generally will move in the same general trend as the Fed Funds rate, but not necessarily in conjunction. If rates are going to rise, typically they’ll rise in the bond market before the Fed ever makes a interest rate policy shift. The same is typically true when rates are declining.

The Fed does not control how much a bank is charging you for a mortgage, a car loan or a credit card. When banks lend money, they will consider many factors in pricing the rate they charge, much like a bond investor. One of the factors a bank will consider is the opportunity cost of lending out that money. In other words, they will consider how much they could make on the dollar they are lending you if they’d invested it in real estate, lent it to another bank, invested it in bonds, or any number of other alternatives. They will consider the risk they are taking by lending it to you and compare it to the risk level of any of the other alternatives. So, while the rate the bank charges you is not controlled by the Fed, the Fed Funds rate certainly plays into the rate they will charge you.

The function of the Fed setting interest rates for bank-to-bank lending is to encourage the loosening and tightening of money supply. When rates are low, banks are more willing to borrow from each other, and use that money to lend to customers. The more money being borrowed by consumers, the more goods and services being exchanged in the economy. So by reducing interest rates, the Fed is trying to encourage more economic activity. Conversely, when they raise rates, they are trying to tighten the money supply to slow down the economy. The reason the Fed would want to slow the economy down is to combat inflation. With too much economic growth, too quickly, we face rapid rising prices, or inflation.