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Do interest rates increase based on what the market is doing, or do they solely increase based on what the Federal Reserve sets them at?

Why is it assumed that interest rates are going to increase when the Federal Reserve ends QE3? I don't understand why interest rates are going to increase.

My main question that I'm trying to understand is why interest rates are what they are. Is it more of an arbitrary number set by central banks or is it due to market activity?

  • You may want to research ideas under Monetary Policy as that is how Central Banks generally set their rates. Increases are often to combat inflation while decreases are intended to stimulate more spending. – JB King Jul 16 '13 at 3:53
  • JB King, why would an interest rate increase combat inflation? Would it cause people to buy bonds which would decrease the money supply? Is that the reason why? – Jon Jul 16 '13 at 4:02
  • Interest rate increases curb spending as it becomes more expensive to borrow. While you may buy a car at 0.9% financing, would you buy it at 20% interest? This is where the high rates can trigger recessions if the Fed wants to battle inflation. Buying bonds would be a secondary consideration as the better question is how cheap or expensive is it to borrow money. If it is cheap, then this is stimulative as people may take advantage of it. The flip side is that high interest rates will likely cause contractions as people and corporations borrow less in these times. – JB King Jul 16 '13 at 16:05
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My answer is specific to the US because you mentioned the Federal Reserve, but a similar system is in place in most countries.

Do interest rates increase based on what the market is doing, or do they solely increase based on what the Federal Reserve sets them at?

There are actually two rates in question here; the Wikipedia article on the federal funds rate has a nice description that I'll summarize here. The interest rate that's usually referred to is the federal funds rate, and it's the rate at which banks can lend money to each other through the Federal Reserve.

  1. The nominal federal funds rate - this is a target set by the Board of Governors of the Federal Reserve at each meeting of the Federal Open Market Committee (FOMC). When you hear in the media that the Fed is changing interest rates, this is almost always what they're referring to.

  2. The actual federal funds rate - through the trading desk of the New York Federal Reserve, the FOMC conducts open market operations to enforce the federal funds rate, thus leading to the actual rate, which is the rate determined by market forces as a result of the Fed's operations. Open market operations involve buying and selling short-term securities in order to influence the rate.

As an example, the current nominal federal funds rate is 0% (in economic parlance, this is known as the Zero Lower Bound (ZLB)), while the actual rate is approximately 25 basis points, or 0.25%.


Why is it assumed that interest rates are going to increase when the Federal Reserve ends QE3? I don't understand why interest rates are going to increase.

In the United States, quantitative easing is actually a little different from the usual open market operations the Fed conducts. Open market operations usually involve the buying and selling of short-term Treasury securities; in QE, however (especially the latest and ongoing round, QE3), the Fed has been purchasing longer-term Treasury securities and mortgage-backed securities (MBS). By purchasing MBS, the Fed is trying to reduce the overall risk of the commercial housing debt market. Furthermore, the demand created by these purchases drives up prices on the debt, which drives down interest rates in the commercial housing market.

To clarify: the debt market I'm referring to is the market for mortgage-backed securities and other debt derivatives (CDO's, for instance). I'll use MBS as an example. The actual mortgages are sold to companies that securitize them by pooling them and issuing securities based on the value of the pool. This process may happen numerous times, since derivatives can be created based on the value of the MBS themselves, which in turn are based on housing debt. In other words, MBS aren't exactly the same thing as housing debt, but they're based on housing debt. It's these packaged securities the Fed is purchasing, not the mortgages themselves.

Once the Fed draws down QE3, however, this demand will probably decrease. As the Fed unloads its balance sheet over several years, and demand decreases throughout the market, prices will fall and interest rates in the commercial housing market will fall. Ideally, the Fed will wait until the economy is healthy enough to absorb the unloading of these securities.

Just to be clear, the interest rates that QE3 are targeting are different from the interest rates you usually hear about. It's possible for the Fed to unwind QE3, while still keeping the "interest rate", i.e. the federal funds rate, near zero. although this is considered unlikely.

Also, the Fed can target long-term vs. short-term interest rates as well, which is once again slightly different from what I talked about above. This was the goal of the Operation Twist program in 2011 (and in the 1960's). Kirill Fuchs gave a great description of the program in this answer, but basically, the Fed purchased long-term securities and sold short-term securities, with the goal of twisting the yield curve to lower long-term interest rates relative to short-term rates. The goal is to encourage people and businesses to take on long-term debt, e.g. mortgages, capital investments, etc.


My main question that I'm trying to understand is why interest rates are what they are. Is it more of an arbitrary number set by central banks or is it due to market activity?

Hopefully I addressed much of this above, but I'll give a quick summary. There are many "interest rates" in numerous different financial markets. The rate most commonly talked about is the nominal federal funds rate that I mentioned above; although it's a target set by the Board of Governors, it's not arbitrary. There's a reason the Federal Reserve hires hundreds of research economists. No central bank arbitrarily sets the interest rate; it's determined as part of an effort to reach certain economic benchmarks for the foreseeable future, whatever those may be.

In the US, current Fed policy maintains that the federal funds rate should be approximately zero until the economy surpasses the unemployment and inflation benchmarks set forth by the Evans Rule (named after Charles Evans, the president of the Federal Reserve Bank of Chicago, who pushed for the rule).

The effective federal funds rate, as well as other rates the Fed has targeted like interest rates on commercial housing debt, long-term rates on Treasury securities, etc. are market driven. The Fed may enter the market, but the same forces of supply and demand are still at work. Although the Fed's actions are controversial, the effects of their actions are still bound by market forces, so the policies and their effects are anything but arbitrary.

  • "By purchasing MBS, the Fed is trying to reduce the overall risk of the commercial housing debt market. Furthermore, the demand created by these purchases drives up prices on the debt, which drives down interest rates in the commercial housing market." - Can you explain what you mean by commercial housing debt market? What do you mean that prices on the debt will increase? I thought debt is just money owed to someone. The way you are explaining this to me is not helping. – Jon Jul 16 '13 at 4:09
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    @Jon In response to your first comment, the Federal Reserve isn't purchasing mortgages; they're purchasing mortgage-backed securities. Companies purchase mortgages (the actual mortgage agreements like the kind you might have with your bank), combine them, and issue derivatives based on that pool. These derivatives are the mortgage-backed securities that the Fed is buying, among other things. – John Bensin Jul 16 '13 at 4:17
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    @Jon Re, 2nd comment: there are several factors that could affect this. Investors may sell bonds now, while the price is high (because of the demand created by the Fed's purchasing program) in order to lock in their gains. The selling decreases the price of those securities, thus increasing the interest rates on those securities. The interest rate I'm referring to in this comment is simply the interest rates on whatever bonds people chose to sell. It's different from the federal funds rate. – John Bensin Jul 16 '13 at 4:20
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    @Jon When "the price of debt increases," this means the on average, the prices of MBS increase. Traders expect the Fed to purchase the securities at any price (within limits), so they can demand a higher price both from the Fed and from other traders. Technically, the company that performed the securitization is taking in the money from the mortgages and paying a fixed-income stream, and that's what the Fed is receiving. The Fed isn't receiving the money from your mortgage directly. – John Bensin Jul 16 '13 at 11:31
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    @Jon The price of an MBS doesn't increase as people pay off their loans; the MBS represents the income stream from the mortgage, which is usually relatively constant even across a pool of mortgages, barring massive defaults a la 2008. I'm simplifying quite a bit here, but that's the general idea. In response to your last comment, most interest rates are set a certain amount above the prime rate, which is in turn based on the fed funds rate. They may have a variable rate portion too, however, like a credit card usually does. – John Bensin Jul 16 '13 at 11:34
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Fundamentally interest rates reflect the time preference people place on money and the things money can buy. If I have a high time preference then I prefer money in my hand versus money promised to me at some date in the future. Thus, I will only loan my money to someone if they offer me an incentive which would be an amount of money to be received in the future that is larger than the amount of money I’m giving the debtor in the present (i.e. the interest rate).

Many factors go into my time preference determination. My demand for cash (i.e. my cash balance), the credit rating of the borrower, the length of the loan, and my expectation of the change in currency value are just a few of the factors that affect what interest rate I will loan money.

The first loan I make will have a lower interest rate than the last loan, ceteris paribus. This is because my supply of cash diminishes with each loan which makes my remaining cash more valuable and a higher interest rate will be needed to entice me to make additional loans. This is the theory behind why interest rates will rise when QE3 or QEinfinity ever stops. QE is where the Federal Reserve cartel prints new money to purchase bonds from cartel banks. If QE slows or ends the supply of money will stop increasing which will make cash more valuable and higher interest rates will be needed to entice creditors to loan money.

Note that increasing the stock of money does not necessarily result in lower interest rates. As stated earlier, the change in value of the currency also affects the interest rate lenders are willing to accept. If the Federal Reserve cartel deposited $1 million everyday into every US citizen’s bank account it wouldn’t take long before lenders demanded very high interest rates as compensation for the decrease in the value of the currency.

Does the Federal Reserve cartel affect interest rates? Yes, in two ways. First, as mentioned before, it prints new money that is loaned to the government. It either purchases the bonds directly or purchases the bonds from cartel banks which give them cash to purchase more government bonds. This keeps demand high for government bonds which lowers the yield on government bonds (yields move inverse to the price of the bond). The Federal Reserve cartel also can provide an unlimited amount of funds at the Federal Funds rate to the cartel member banks. Banks can borrow at this rate and then proceed to make loans at a higher rate and pocket the difference.

Remember, however, that the Federal Reserve cartel is not the only market participant. Other bond holders, such as foreign governments and pension funds, buy and sell US bonds. At some point they could demand higher rates. The Federal Reserve cartel, which currently holds close to 17% of US public debt, could attempt to keep rates low by printing new money to buy all existing US bonds to prevent the yield on bonds from going up. At that point, however, holding US dollars becomes very dangerous as it is apparent the Federal Reserve cartel is just a money printing machine for the US government. That’s when most people begin to dump dollars en masse.

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    "The Federal Reserve cartel, which currently holds close to 50% of US debt..." Where do you get this figure? I'm looking at the raw data from the Treasury Department and I don't see that. I think you're confusing "Federal Reserve and intragovernmental holdings" with "the Federal Reserve." These aren't equivalent because intragovernmental holdings include funds like Social Security, whose holdings dwarf those of the Federal Reserve by an order of magnitude. – John Bensin Jul 18 '13 at 18:09
  • good catch. Fixed. – Muro Jul 18 '13 at 18:55
  • Thanks for the correction. The 50% figure has been tossed around for a while and seems to have seeped into the public mind, but it's so wildly far from the truth that I always point it out. Nothing beats checking the raw data. – John Bensin Jul 18 '13 at 19:28

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