Money is a commodity like any other and like other commodities, money can be lent by those with a surplus to those with a deficit. The price which those with surplus funds charge for the use of funds is called the interest rate.
The Loanable Funds Market
The supply of loanable funds ultimately comes from households (globally) who have chosen to defer consumption. Households lend these funds through the use of financial intermediaries, such as banks and investment management firms, who earn fees for managing household savings. To compensate these households for deferring consumption, borrowers must pay a rate of interest adequate to provide enough savings to satisfy the demand for loanable funds.
Demand for loanable funds comes from governments and firms who borrow money to finance expenditures.
Interest rates are prices like any other and are, thus, set by the forces of supply and demand within the loanable funds market. The equilibrium interest rate is the rate at which the demand for loanable funds exactly equals the supply of loanable funds. If interest rates fall below the equilibrium rate, demand for loanable funds would increase beyond the supply of loanable funds, and lenders would raise rates and bring the market back into balance. Conversely, if rates rise above the equilibrium rate, the supply of funds would increase beyond the demand for funds, and lenders would lower rates.
The Treasury Market
There are, of course, many types of borrowers. But the most important of these is the U.S. government, which borrows money in the form of Treasury securities. There are several reasons to understand the Treasury market. First, treasury securities are theoretically free of default risk, and thus serve as the “risk-free” rate used in asset pricing models. Second, Treasury securities are used as benchmark rates when pricing loans and credit instruments. For example, mortgage rates closely follow the 10-year Treasury note.
Treasury securities come in three forms, based on their maturity terms from origination. These three forms are Treasury bills, Treasury notes, and Treasury bonds.
Treasury bills are instruments which the Treasury issues for terms ranging from four to 52 weeks. These bills are “discount securities” – i.e., they make no interest payments but are rather issued at a discount from their face value. The difference between the bill’s price and its face value represents the interest.
Treasury notes are instruments with original maturities ranging from 2 to 10 years. These instruments pay a fixed rate of interest every six months. The yearly interest stated as a percentage of the price at origination is called the coupon rate (the payments are referred to as the coupon). However, notes trade in an active secondary market and prices can deviate from the note’s original price. The yield refers to the interest as a percentage of the current price. Treasury note yields are important for investors as they are used to price “risk” assets such as stocks, commercial real estate, and private equity investments.
Treasury bonds are instruments issued by the Treasury at maturities greater than 10 years up to 30 years. Currently, the Treasury issues Treasury bonds in 20- and 30-year maturities. Like Treasury notes, Treasury bonds pay interest every six months.
Real vs. Nominal Rates
If we confine our discussion of interest rates to the Treasury market, we can say that interest rates consist of the following three components: (a) expected inflation, (b) average of expected short-term (real) rates, and (c) term premiums.
Nominal rates are rates which consist of all three components listed above. In other words, nominal rates are unadjusted for expected inflation. In contrast, real rates consist of (b) and (c) above and thus represent the inflation adjusted return.
In 1997, the Treasury began issuing instruments called Treasury Inflation Protected Securities (TIPS). The Treasury issues these instruments with a fixed interest rate but adjusts the principal based on changes in the consumer price index. However, TIPS never pay below the original principal amount. This way, the investor is hedged against both inflation and deflation.
The Treasury currently issues TIPS in 5-, 10-, and 30-year maturities. One of the benefits of the TIPS market is that we can calculate the market’s expected inflation rate by subtracting the TIPS rate from the rate on a Treasury with a corresponding maturity. For example, if a 10-year Treasury security is yielding 4.25% and the TIPS rate is 2%, then an estimate of expected inflation over the ten-year term is 2.25%.
Term Structure of Interest Rates
The Treasury market’s term structure refers to the interest rate differential between Treasury securities of different maturities.
We can represent the term structure graphically by plotting the maturity terms and corresponding yields. Such a graph is called the Treasury yield curve. The yield curve is generally upward sloping, indicating that interest rates increase as terms lengthen.
Occasionally, longer-term rates drop below short-term rates, leading to an inverted yield curve. Inverted yield curves are of special consideration for investors as inversion often precedes an economic slowdown.
To see why an inverted yield curve is so important, we must consider that the most widely cited theory for explaining the interest rate term structure is the liquidity preference theory. We stated the liquidity preference theory above when we recognized that nominal Treasury rates consist of three components: (a) an expected inflation rate, (b) an average of expected (real) short-term rates, and (c) a term premium. The term premium represents the fact that the market for longer-term Treasury securities is less liquid than the market for short-term Treasury bills, thus leading investors to require a small premium to compensate them for the incremental liquidity risk.
Assuming that (a) and (c) above are constant, an inverted yield curve implies that the bond market expects the Federal Reserve to lower short-term rates in the future. More importantly is that the bond market is, by inference, predicting slower economic conditions leading to lower short-term rates.
How the Fed Influences Interest Rates
During most of the post-war period, the Fed influenced short-term rates though open-market operations, which would expand or contract bank reserves and would alter money-market conditions accordingly. From the 1950s to the financial crisis, the Fed operated a policy of “bills only”, meaning they conducted open market operations exclusively through sales and purchases of Treasury bills. Longer-term rates were affected as well, but generally the relationship between short-term and long-term rates resulted in a relatively steep yield curve.
As a response to the financial crisis, the Fed engaged in several rounds of large-scale asset purchases, a program which became known in the media and the investment profession as “quantitative easing.”
The purpose of quantitative easing was to loosen conditions in the mortgage market and bring down longer-term interest rates. The Fed accomplished this by purchasing longer-term Treasury and mortgage securities. Thus, quantitative easing was an expansive form of open-market operations which departed from the Fed’s traditional “bills only” policy. Quantitative easing became a new policy tool which the Fed could use to influence longer-term interest rates.
One consequence of quantitative easing was to flood the banking system with reserves, rendering traditional open market operations ineffective at influencing short-term rates. As a result, the Fed began to shift to a “floor system,” in which it used a new tool, interest on reserves held at the Fed, to influence short-term rates.
In addition to quantitative easing, the Fed can use its communication strategy to influence longer-term rates and “flatten the yield curve.” The Federal Reserve began to liberalize its communications strategy under Ben Bernanke, and his predecessors have continued to enhance the effectiveness of this tool. Former Fed Chair Bernanke was so convinced of the power of communication as to refer to central banking as “98% talk and 2% action.”
The Fed’s communication strategy influences long-term rates through two primary means. First, the Fed can use its communications strategy to shape inflation expectations. As long as the Fed can maintain its inflation-fighting credibility, it can lower the expected inflation embedded in long-term rates. Second, and perhaps most important, the Fed can use “forward guidance.” The Fed uses forward guidance by communicating its intention to keep short-term rates low for a prolonged period, thus reducing the path of expected short-term rates embedded in longer-term rates.
Conclusion
Interest rates are the prices charged by lenders for the use of borrowed funds. Like all prices, interest rates are influenced by the forces of supply and demand.
The largest and most important rate market is the market for U.S. Treasury securities. Because this market provides the least risk, rates set in this market function as benchmarks for all borrowing within the economy.
The Federal Reserve has direct influence on credit conditions and interest rates. When influencing short-term rates, the Fed uses a floor system which establishes the minimum rates on money-market instruments, including rates on U.S. Treasury bills. The Fed can also influence longer-term interest rates through direct asset purchases (quantitative easing) and by using its communications strategy to shape expectations.
Sources:
Bernanke, Ben. 21ST Century Monetary Policy: The Federal Reserve from the Great Inflation to COVID-19. New York: Norton, 2022.
Crescenzi, Anthony. The Strategic Bond Investor, 3rd ed. New York: McGraw-Hill, 2021.
Mishkin, Frederic. The Economics of Money, Banking, and Financial Markets, 2nd ed. New York: Addison-Wesley, 2010.
