What Drives Interest Rates?

Casey F.

Have you been watching interest rates going up and down, and wondered why?  What drives interest rates?  Are they totally unpredictable, or can we get a sense for what direction interest rates are headed?

As it turns out, they are not totally random.  You just have to think like an investor rather than a borrower.  Let’s take a look:

Interest Rates and Inflation

The three most important factors in interest rates are inflation, inflation and inflation.  (Or, rather, the expectation of inflation.)  Why is this?

Let’s say I want to borrow $100 from you.  I promise to pay you back your $100 in exactly 1 year, plus $5 interest.  You’ll make 5% on your money – much better than a savings account!

Steak dinners are a perfect metaphor for inflation
How does a steak dinner relate to interest rates? Photo by Loija Nguyen on Unsplash

However, your sweetheart made you promise to take her out for a steak dinner, which would cost exactly $100 today.  Now you have a choice – enjoy the steak dinner with your sweetheart now, or delay the steak dinner for a year and get the steak dinner plus have $5 left over.

However, there’s a problem with this.  What happens if inflation is running at 5%?  A year from now the steak dinner will cost $105, not $100.  You have gained nothing!  The buying power of your money diminished as fast as you earned interest on it, and you lost the use of it for an entire year!

Think Like an Investor

In order to receive more dollars back on your investment, therefore, you must earn more than the inflation rate.

Institutional investors who invest billions of dollars understand this principal very well.  They “lend” money to you (through banks and other types of lenders) by lending money to the lenders.  (They do this by buying securities, or effectively promissory notes.)

So, if an investor needs to earn more than inflation when they invest money, the number one factor in how much they need to earn is what they expect inflation to run over the course of their investment.

Now you know.

Casey Fleming is a mortgage broker in Silicon Valley, CA and regularly writes columns for this and other financial web sites.