5 Reasons whyyou’re Getting That Interest Rate Today

  • By Jennifer Calonia
  • September 8, 2014

Interest rates todayare speculated to remain at a low well into 2015, which directly influences consumers’ ability to earn decent returns on deposit accounts.Despite this reality, not many Americans truly comprehendhow banks set interest ratesand what factors play a role in how rates change.

Bank interest ratesaren’t simply determined at the whim of any given bank or credit union, with no direction or benchmark. On the contrary, there are a handful of key elements that sway interest rates today in consumers’ favor, or against it.

1.Federal Reserve Requirements

The Fed enforces a minimum reserve requirement, also called a cash reserve ratio, on banks that are members of theFederal Reserve. These institutions are required to withhold a percentage of their liabilities in either a cash vault or in a Federal Reserve Bank at all times.

Each year, the Fed assesses how much in cash reserves financial institutions must set aside; the requirements are outlined in the Federal Reserve Board’s Regulation D.

Reserve percentage requirements are based on a bank’s net transaction accounts (such aschecking accounts), which are as follows:

  • $0 – $12.4 million: Zero percent in reserves
  • $12.4 million – $79.5 million: 3 percent in cash reserves
  • Over $79.5 million: 10 percent in reserve requirements withheld

Why does all this matter? Banks that don’t have enough depositors to uphold their reserve requirements have the option to borrow funds from other banks through short-term loans to ensure the reserve requirement is met.

Banks are then charged interest by other banks on the loan, which is calledtheFederal Funds Rate — this cost of borrowing money is passed on to consumers via bank interest rates and adjustments on loan products like auto and mortgage loans.

2.Discount Rate

The discount rate is another benchmark which determineshow banks set interest rates. In addition to giving banks the option to lendamongone another, the Fed itself provides loans to help banks meet the reserve requirement at a “discount rate” for the loan.

This direct loan from the Federal Reserve is typically higher than the Federal Funds Rate, but has recently been lowered to supply institutions with a greater ability to provide loans to businesses and consumers. The lower the rate banks have to pay when borrowing funds from the Fed, the more affordable lending interest rates today are for consumers.

3. Anticipated Inflation

When financial institutions determine the deposit and loan rates offered to customers, consideration is given to the potential inflation rate anticipated in the future.

Fergus Hodgson, Director of Fiscal Policy Studiesfor theJohn Locke Foundationin North Carolina, shares why this seemingly convoluted concept makes a great deal of difference on interest rates today.

“Inflation, the devaluation of a currency expressed in higher price levels, is one of two underlying drivers of retail interest rates — the other is the activity of the Federal Reserve system,” Hodgson said. “In the presence of higher inflation, which the United States is beginning to experience, lenders need to raise their rates in order to generate a return. Relatively speaking, the money they receive when paid back will be less valuable, which offsets the interest rate charged.”

As lenders attempt to compensate for the rate of inflation, borrowers will likely continue seeing bank interest rates follow in suit.

“Consider a mortgage loan at an interest rate of 5 percent, alongside an inflation rate of 2 percent. Therealinterest rate or return to the financial intermediary is 3 percent annually. If the rate of inflation were to rise to 5 percent, the intermediary would need to offer comparable loans at a rate of 8 percent for an equal return,” Hodgson said.

4. Demand For Loans

The fundamental idea of supply and demand resonates strongly with how interest rates are set as well. Since the economic recession, for example, fewer Americans have been financially capable — let alone willing — to take on large amounts of debt, such as a mortgage loan toward a home purchase. Anover-saturatedmortgage market (i.e. higher supply of mortgage loans) results in lower loan rates due to a lack of demand. The reverse also functions in the same way.

5. Risk of Default

Lenders always take on a certain level of risk when lending money to borrowers. Those with a history of late payments or poor credit, for example, will likely exhibit the same dangerous financial behavior with a newly acquired loan.

For this reason, bank interest rates are increased on loans by financial institutions in an effort to hasten and secure the return of their money in the event borrowers don’t make good on their promise to repay the loan within the predetermined term.

While a lot of the factors affecting interest rates today are out of consumers’ immediate control, maintaining a clean line of credit and taking the initiative to shop around for the best bank interest rates in the area opens the door to interest rates on deposit and loan products that meet customers’ needs.

Zero interest-rate policy (ZIRP) is a macroeconomic concept describing conditions with a very low nominal interest rate, such as those in contemporary Japan and, since December 16, 2008, in the United States. It can be associated with slow economic growth.

Under ZIRP, the central bank maintains a 0% nominal interest rate. The ZIRP is an important milestone in monetary policy because the central bank is no longer able to reduce nominal interest rates—it is at the zero lower bound. Conventional monetary policy is at its maximum potential to drive growth under ZIRP. ZIRP is very closely related to the problem of a liquidity trap, where nominal interest rates cannot adjust downward at a time when savings exceed investment.

However, some economists—such as market monetarists—believe that unconventional monetary policy such as quantitative easing can be effective at the zero lower bound.

Others argue that when monetary policy is already used to maximum effect, to create further jobs, governments must use fiscal policy. The fiscal multiplier of government spending is expected to be larger when nominal interest rates are zero than they would be when nominal interest rates are above zero. Keynesian economics holds that the multiplier is above one, meaning government spending effectively boosts output. In his paper on this topic, Michael Woodford finds that, in a ZIRP situation, the optimal policy for government is to spend enough in stimulus to cover the entire output gap.[1]

Chris Modica and Warren Sulmasy find that the ZIRP policy follows from the need to refinance a high level of US public debt and from the need to recapitalize the world's banking system in the wake of the Financial crisis of 2007–2008.[2]

Zero lower bound

The zero lower bound problem refers to a situation in which the short-term nominal interest rate is zero, or just above zero, causing a liquidity trap and limiting the capacity that the central bank has to stimulate economic growth. This problem returned to prominence with the Japan's experience during the 90's, and more recently with the subprime crisis. The belief that monetary policy under the ZLB was effective in promoting economy growth has been critiqued by economists Paul Krugman, GautiEggertsson, and Michael Woodford among others. Milton Friedman, on the other hand, argued that a zero nominal interest rate presents no problem for monetary policy. According to Friedman, a central bank can increase the monetary base even if the interest rate vanishes; it only needs to continue buying bonds.[3] (Note: The quote from footnote #3 may be misleading. Friedman was talking about Japan in 1989, when Japan's very tight monetary policy produced deflation which resulted in a zero interest rate. Friedman wasn't exactly advocating the "Quantitative Easing" that's been the Fed's strategy from 2008 to 2014. (7/30/2014))

Wikipedia.