How and why do interest rates increase?
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Central banks control and generate/print money and inject it into the market. Banks take this loan from it, and then lend the money to you.
Banks do pay interest for their loans. The interest rate you mean is this one. They pay this to the central bank. They lend this money to you at a higher interest rate since they need to profit too.
Lower interest rates mean people can borrow and spend money easily. This creates devaluation in the money and creates inflation. Higher interest rates mean the opposite. Higher interest rate also bears a risk because the largest borrower is usually governments.
When we talk about “interest rate rises” we’re usually talking about the rate charged by central banks (eg. the Bank of England, European Central Bank, US Federal Reserve). This is often called the “base rate”.
This is linked to the rates charged and offered by other banks and lending institutions, but it’s not the only factor. Rates on mortgages, for example, can go up or down for other reasons, such as the availability of funds or the risk of people not paying.
Back to the central bank though. When they lend money, commercial banks have to borrow money from the central bank. If the central bank’s interest rate goes up, lending becomes more expensive for commercial banks. They then increase their interest rates to cover the cost.
This has a number of economic effects.
Lower interest rates encourage borrowing. They tend to encourage economic growth, and they make things easier for existing borrowers.
Higher interest rates attract money from other countries. If I’m trying to decide whether to hold my money in pounds sterling or dollars, one of the things I’ll consider is where I’ll get the best interest rate. This tends to push up the value of the currency, making imports cheaper and exports more expensive, and lowering inflation.
High interest rates also reduce the amount of money in circulation *edit: or more likely, slow its growth*. This is because commercial banks create money when they make loans. The higher the cost of taking out a loan, the less people will borrow, and thus the less money is created. This tends to reduce inflation.
Simple supply and demand usually.
Economies demand certain amounts of loans, there is only a certain amount of money to loan out. If we reduce the amount of money to loan out, supply and demand says the price of these loans (aka interest) has to increase.
Central banks have a couple of levers they can push to change the amount of possible money to loan out. They can have banks hold more money in reserves that they can’t loan. Central banks themselves loan money printed out of thin air and this also increases the supply of loaned money, they can just do less of this as well or charge higher interest to do it.
The central banks control interest rates through three (or four) basic ways. Basically, banks often have excess funds or need funds, and to handle those shortfalls can either borrow/lend from each other or the federal reserve.
1. Setting the reserve rate. Banks keep an account at the federal reserve, and it’s generally considered extremely safe, given that it’s the federal reserve an all. When the Fed increases the interest those accounts pay, that serves as the lowest rate banks will be willing to lend out their own funds. The reason is that if the Fed is the safest “borrower” vs. other banks, the interest they would receive from anyone else must be higher than this rate to compensate for the risk. This sets a floor for bank-to-bank lending.
2. Rate on Overnight Reverse Repo: Think of it as similar to #1 in that it’s what other financial institutions can get from lending to the Fed. This sets a floor for bank-to-bank lending.
3. Discount Window: When banks need money, they can borrow from the Fed and the fed controls the rate. That sets a ceiling, because a bank who needs liquidity will likely not borrow for a higher rate than they could get from the federal reserve, so this sets a ceiling for bank-to-bank lending.
Through these tools, the federal reserve seeks to affect the rate at which banks lend to each other, called the federal funds rate which they “target” but technically don’t control. There is no rule or law that says that banks have to base the interest rates offered to customers around these rates. It’s just that these tools are so powerful that it ends up making the financial world conform to these standards. If a bank can get 5% lending to another bank overnight, they probably won’t lend at 5% on a much riskier mortgage. Maybe they now need 7%. However, if they lend at 10% no one would sign up for that loan because other banks will offer 7%, so it’s kind of market forces that affect it but the driver really is the federal reserve.
So now the why. Low interest rates are great because they stimulate the economy. When rates are low, people borrow more to buy houses, cars, start business, etc. It’s all good, until that excess demand causes runaway inflation. It also tends to lead to a lot of crap businesses that stay alive just because the economy is good enough and interest payments are low, so it “crowds out” the opportunity for new, better businesses to come in. Overtime this makes an economy less strong, so when you raise interest rates, it causes lending to tighten, which shrinks demand and inflation, and also causes these crap businesses to restructure or liquidate. Economists debate this of course but that’s the general theory.
I said there were four, so here’s the fourth. Open-Market Operations/Quantitative Easing: If rates are already low but the Fed wants to stimulate the economy even more, they go into the treasury market and purchase treasuries or other securities at set intervals. The best way to ELI5 I can think of for this is: Let’s say you treasury bonds that sell for 95 and at the end of the year pay 100 and have no interest/coupon for simplicity. If you buy one now, you’ll make $5 on that investment. Well let’s the Federal reserve comes in and buys huge swaths of those bonds each month that will push the price up to say $98. Well let’s say you have a mandate where you must earn $5, well now you’re going to go invest in something else, probably more risky, which stimulates demand (even if only artificially). It’s how the Fed propped up the US economy during the GFC and also COVID lockdowns.
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