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.

Find out about Current Mortgage Rates

See Today's Interest Rates

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.