Cause and Effect of Interest Rates
Interest rates on home mortgages are important because mortgage interest is a major item in many people’s budgets. Even small changes in mortgage interest rates can have a large impact on how affordable it is to own a home. And since homeownership is the main way many families accumulate wealth, affordable rates are important.
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Interest Rates and Supply and Demand
The prices of interest rate futures, like those for other future contracts, react to fundamental factors of supply and demand. In this instance, price levels of interest rate futures are affected by the supply of, as well as the demand for credit.
How Credit is Affected
Credit, in turn, is affected by economic forces in several areas, among them: Federal Reserve Board monetary policy, legislative and executive fiscal policies, business activity and inflationary expectations.
Generally, interest rate futures will rise in price amid signs of a slowing economy since a sluggish economy reduces credit demand. On the other hand, a strong economy generally lowers future prices since increased credit demand tends to force interest rates higher.
Economic Indicators
Numerous economic indicators are closely watched by users of the financial futures markets. Outlined below are several of the more closely watched indicators, as well as what generally happens once the developments are announced.
Federal Reserve Board Policy
Reasons Interest Rates Go Down
| Activity |
Reason |
Fed does repurchase agreements |
Fed puts money into banking system by purchasing collateral and agreeing to resell later. This helps bring rates down. |
Fed buys bills |
Fed permanently adds to banking system reserves, which may cause interest rates to drop. |
Reasons Interest Rates Go Up
| Activity |
Reason |
Fed raises discount rate |
An increase in the borrowing rate from the Fed usually results in increased rates for a bank’s customers. This action is used to slow credit expansion. |
Money supply increases currency in public’s hands: travelers checks; checking account funds; NOW and super NOW accounts; automatic transfer service accounts; balances in credit union accounts; M1 savings; and small time deposits (less than $100,000) at depository institutions; overnight repurchase agreements at commercial banks; money market mutual fund accounts; M2 large time deposits ($100,000 or more) at depository institutions; repurchase agreements with maturities longer than one day at commercial banks and institutional money market accounts. |
Excess money supply growth can potentially cause inflation and generate fears the Fed may tighten money growth by allowing the Fed funds rate to rise, which in turn, lowers futures prices. |
Fed does reverses or matched sales |
Fed takes money from the System by selling collateral and agreeing to repurchase at a later date. This decrease in the money supply typically raises interest rates. |
Business Activity
Reasons Interest Rates Go Down
| Activity |
Reason |
Gross National Product |
Reflects a slowing economy. Fed may loosen money supply prompting a decline in interest. |
Industrial production falls |
Indicates slowing economic growth. Fed may be more accommodating by allowing interest rates to fall to stimulate the economy. |
Inventories up |
Indicates slowing economy |
Oil prices fall |
Reduces upward pressure on interest rates, thereby enhancing prices of debt securities. |
Precious metals prices fall |
Reflects decreased inflation. Demand for inflation hedges abates. |
Unemployment rises |
Indicates slow economic growth. Fed may ease credit, causing rates to drop. |
Reasons Interest Rates Go Up
| Activity |
Reason |
Consumer price index rises |
Indicates rising inflation. |
Durable goods orders rise |
Pickup in business activity usually leads to increased credit demand. |
Housing starts to rise |
Indicates growth in economy and increased credit demand. Fed is less accommodating and may attempt tightening by allowing rates to rise. |
Leading indicators up |
Signals strength in economy leading to greater credit demand. |
Personal income rises |
The higher one’s income, the more is consumed, prompting increased demand and higher prices for consumer goods. |
Producer price index rises |
Indicates rising inflation. Demand for goods rises as well as prices. Investors require higher rates of return. |
Retail Sales rise |
Indicates stronger economic growth. Fed tightens purse strings. |
