Why are interest rates so low?

What makes interest rates move, anyway?

Think of interest rates as the "price" of money.  If you are borrowing money, you pay a price to have access to that money--the interest rate. In the same way, if you lend your money, you expect to be paid a price for giving up your money.

Knowing that, interest rates become much easier to understand.

Supply and Demand

If you understand supply and demand, you can understand what makes interest rates move up and down. Higher supplies of money will usually lead to lower interest rates, while higher demand for money will generally lead to higher interest rates. 

By the same token, if supply falls while demand stays the same the price of money should rise - higher rates. If demand falls while supply stays the same, the price of money will normally fall - lower rates.

For an overly simple example, in the late 1970's and early 1980's, the oldest baby boomers began to borrow money to buy their first homes.  The demand for money increased dramatically, and we had higher interest rates.

Conversely, those same baby boomers are now entering their 70's. They are paying off those mortgages and saving their money instead of borrowing.  Now supply is higher, which leads to lower rates.

These are simplistic examples, and other forces can affect supply and demand as well.  But the concept is the same. It all boils down to supply and demand.  Here are a few:

• Corporations borrow more money = demand = higher rates
• Corporations pay down their debt = lower demand = lower rates
• Foreign nations invest their reserves in US debt = higher supply = lower rates
• Foreign nations move money away from the US = lower supply = higher rates

The Fed

The Federal Reserve Bank (Fed) also has a major effect on interest rates. In fact, their monetary policy involves directly managing interest rates.  But this monetary policy is just a means to and end. That end is a "dual mandate" from Congress.  The Fed's mandate is to seek maximum employment and stable prices in the United States.  Knowing this will help you understand the Fed's intentions when they adjust their policies.  Here are some examples.

Maximizing Employment

If the Fed wants to increase employment, they may want to stimulate the economy. This can be done in a number of ways, but generally, it means lowering interest rates.  Lower rates make it easier for businesses to grow, and for individuals to increase their spending through mortgages and credit. This leads to spending, which grows the economy, which leads to more jobs.  Here are some ways the Fed can lower rates:

• Lowering the Fed Funds or Discount Rate to banks.
• Buying securities like bonds and loans from the open market (A.K.A. "quantitative easing")

Stabilizing Prices

If the Fed wants to manipulate prices, they can also control the amount of currency in the economy--the money supply.  If a lot of money is in our economy, prices tend to rise.  On the other hand, if less money is in our economy, prices will tend to fall.  

If prices are falling, the Fed may want to increase the money supply to keep prices stable.  If inflation is running away, like in the late 1970's, the Fed may want to reduce the money supply, so that prices can fall a bit.

This is a vast simplification of a complex economy, but if you think about interest rates as the Price Of Money, it makes things a little easier to understand.  Please contact us if you have questions.  We can be reached by email at advisors@athenaprivatewealth.com, or at http://athenaprivatewealth.com. We are also on Twitter and Facebook.  Look for the links on our website.