How and why do interest rates increase?
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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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