What Affects Interest Rates

The single biggest factor affecting interest rates is inflation, which increases interest rates as lenders demand higher returns to keep pace with rising prices, such as when the US Federal Reserve raised the federal funds rate to 5% in 2006 to combat inflation that had reached 3.2% (Bureau of Labor Statistics).

Main Factors

• Inflation — as inflation rises, lenders increase interest rates to maintain the purchasing power of their investments, increasing interest rates, for example, when the US inflation rate rose from 2% to 4%, the 10-year Treasury yield increased from 2.5% to 4.5% (US Treasury Department).
• Economic growth — strong economic growth increases interest rates as borrowers are more likely to take on debt to finance investments, increasing interest rates, as seen in the 1990s when the US GDP growth rate averaged 3.8% and the federal funds rate rose from 3% to 6% (Bureau of Economic Analysis).
• Central bank policy — expansionary monetary policies, such as quantitative easing, decrease interest rates by flooding the market with liquidity, decreasing interest rates, for instance, when the European Central Bank implemented quantitative easing in 2015, the eurozone's benchmark interest rate fell to 0% (European Central Bank).
• Government debt — high levels of government debt can increase interest rates as investors demand higher returns to compensate for the increased credit risk, increasing interest rates, such as when the US debt-to-GDP ratio rose from 60% to 100%, the 10-year Treasury yield increased from 4% to 6% (Congressional Budget Office).
• Foreign exchange rates — a strong currency can decrease interest rates by reducing the cost of imports and increasing the competitiveness of exports, decreasing interest rates, for example, when the US dollar appreciated by 20% against the euro, the US inflation rate fell from 3% to 2% and interest rates decreased (Federal Reserve Economic Data).
• Default risk — high default risk increases interest rates as lenders demand higher returns to compensate for the increased credit risk, increasing interest rates, such as when the default rate on US corporate bonds rose from 2% to 5%, the yield on high-yield bonds increased from 6% to 10% (Moody's Investors Service).
• Liquidity — low liquidity increases interest rates as investors demand higher returns to compensate for the reduced ability to buy or sell securities quickly, increasing interest rates, for instance, when the US Treasury market experienced a liquidity crisis in 2008, the 10-year Treasury yield rose from 3% to 4% (US Treasury Department).

How They Interact

The interaction between inflation and central bank policy is a key factor in determining interest rates, as central banks use monetary policy to combat inflation, such as when the US Federal Reserve raised the federal funds rate to 5% in 2006 to combat inflation that had reached 3.2% (Bureau of Labor Statistics). The interaction between economic growth and government debt can also be significant, as strong economic growth can increase tax revenues and reduce the burden of government debt, such as when the US GDP growth rate averaged 3.8% in the 1990s and the federal budget deficit fell from 4% to 2% of GDP (Bureau of Economic Analysis). The interaction between foreign exchange rates and default risk can also be important, as a strong currency can reduce the cost of imports and increase the competitiveness of exports, but also increase the default risk of foreign borrowers, such as when the US dollar appreciated by 20% against the euro and the default rate on European corporate bonds rose from 2% to 5% (Moody's Investors Service).

Controllable vs Uncontrollable

The controllable factors include central bank policy, which is controlled by central banks, and government debt, which is controlled by governments. Central banks can use monetary policy to increase or decrease interest rates, such as by setting the federal funds rate or implementing quantitative easing. Governments can use fiscal policy to increase or decrease government debt, such as by increasing or decreasing government spending or taxation. The uncontrollable factors include inflation, economic growth, foreign exchange rates, default risk, and liquidity, which are influenced by a wide range of factors, including global events, technological changes, and demographic trends. While governments and central banks can use policy to influence these factors, they are ultimately outside of their control.