Chapter 6 Interest Rates 1836-7 MACROECONOMIC FACTORS THAT INFLUENCE
INTEREST RATE LEVELS
We described how key components such as expected in" ation, default risk, matu-
rity risk, and liquidity concerns in" uence the level of interest rates over time and
across different markets. On a day-to-day basis, a variety of macroeconomic fac-
tors may in" uence one or more of these components; hence, macroeconomic
factors have an important effect on both the general level of interest rates and the
shape of the yield curve. The primary factors are (1) Federal Reserve policy;
(2) the federal budget de! cit or surplus; (3) international factors, including the
foreign trade balance and interest rates in other countries; and (4) the level of
business activity.
6-7a Federal Reserve Policy
As you probably learned in your economics courses, (1) the money supply has a
signi! cant effect on the level of economic activity, in" ation, and interest rates, and
(2) in the United States, the Federal Reserve Board controls the money supply. If
the Fed wants to stimulate the economy, it increases the money supply. The Fed
buys and sells short-term securities, so the initial effect of a monetary easing would
be to cause short-term rates to decline. However, a larger money supply might
lead to an increase in expected future in" ation, which would cause long-term rates
to rise even as short-term rates fell. The reverse holds if the Fed tightens the money
supply.
As you can see from Figure 6-2, interest rates in recent years have been rela-
tively low, with short-term rates especially low in 2003 and 2004. Those low rates
enabled mortgage banks to write adjustable rate mortgage loans with very favor-
able rates, and that helped stimulate a huge housing boom along with growth of
the economy. The Fed became concerned that the economy would overheat; so
from 2004 to 2006, it raised its target rate 17 times, going from 2.0% to 5.25% in
- Long-term rates remained relatively stable during those years.
The Fed left its target rate unchanged from June 2006 to September 2007, but the
subprime credit crunch that began in 2007 caused increasing concerns about a possi-
ble recession. Those fears led the Fed to cut rates! ve times from September 2007 to
February 2008, taking the target rate down from 5.25% to 3.00%. The Fed also
signaled that more cuts were likely in the coming few months.
Actions that lower short-term rates won’t necessarily lower long-term rates.
This point was made in the following quote from the online edition of Investors’
Business Daily on February 15, 2008:
U.S. government debt prices ended mostly lower Thursday, led by long-dated
issues, as traders turned their focus to potential in! ation risks resulting from
additional interest rate cuts signaled by the Federal Reserve.
It was a rough day for the Treasuries market, as traders concluded that more Fed
rate cuts and the government’s " scal stimulus program would come at the ex-
pense of higher long-term in! ation.
“Fiscal and monetary stimuli are focused on the current strain in the " nancial
markets and its effect on the economy, but there are fears about what these actions
may do to in! ation down the road,” said Tom Sapio, a managing director at
Cantor Fitzgerald in New York.
Lower rates could also cause foreigners to sell their holdings of U.S. bonds.
These investors would be paid with dollars, which they would then sell to buy
their own currencies. The sale of dollars and the purchase of other currencies
The home page for the Board
of Governors of the Federal
Reserve System can be found
at http://www.federalreserve
.gov. You can access general
information about the
Federal Reserve, including
press releases, speeches, and
monetary policy.