When interest rates rise or fall, the ripple effects are felt across the investing world—impacting everything from mortgage payments and bond yields to stock valuations and economic growth. But what exactly causes interest rates to change? The answer is not as simple as the actions of the Federal Reserve. Instead, interest rates move based on a complex web of variables—some driven by policy, others by economic forces and investor behavior.
The Federal Reserve and Monetary Policy
The most well-known factor influencing interest rates is the Federal Reserve, which sets the federal funds rate—the short-term rate at which banks lend to each other overnight. The Fed uses this tool to either stimulate economic activity (by lowering rates) or cool inflation (by raising them). While the federal funds rate doesn’t directly set mortgage or credit card rates, it strongly influences them.
Inflation Expectations
Interest rates and inflation are closely tied. When inflation rises, lenders demand higher interest to compensate for the reduced purchasing power of future repayments. Conversely, when inflation falls or remains under control, it puts downward pressure on rates. Investors pay close attention to inflation data—such as the Consumer Price Index (CPI) and the Fed’s preferred measure, Core PCE inflation.
Economic Growth and Labor Market Conditions
Stronger economic growth typically leads to rising rates. That’s because a robust economy can support higher borrowing costs, and the Fed often raises rates to prevent the economy from overheating. Key indicators like GDP growth, unemployment, job creation and wage gains all play a role in the Fed’s decisions and the broader interest rate environment.
Global Demand for U.S. Treasuries
Interest rates are also shaped by supply and demand in the bond market. When demand for U.S. Treasuries is high—often in times of global uncertainty—yields tend to fall. When demand weakens, yields rise. Foreign central banks, pension funds and other categories of investors or traders all affect this balance.
The Bottom Line
Interest rates don’t move in a vacuum. They respond to host of inputs: inflation trends, economic data, central bank policy and global capital flows. For investors, understanding these drivers is key to navigating market volatility and positioning portfolios for long-term success.
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Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. This report should only be considered as a tool in any investment decision and should not be used by itself to make investment decisions. Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.
