Why Do Interest Rates Fall?


Two major factors that affect interest rates are the Federal Reserve's monetary policy and economic/market conditions, both of which are interconnected. The constant rise and fall of interest rates is part of the continuous economic cycle, so falling interest rates typically correspond to a particular segment of it.

What Are Interest Rates?

Simply put, interest rates are the price of money. When businesses and consumers borrow more, the demand for money increases, and its price -- interest rates -- goes up. When businesses and consumers borrow less, the demand for money drops, and interest rates go down.

Economic Cycle

There is no permanent or consistent level of interest rates; they are constantly moving up and down with the economic cycle although their absolute levels change over time to reflect the sum total of economic, fiscal and political conditions. The economy is like a living, breathing organism: it alternately expands and contracts. During expansion, the demand for goods and services grows, businesses expand, consumers step up purchases and interest rates rise. But rising interest rates and rising inflation eventually curtail demand as businesses and consumers become unwilling or unable to pay more, and the economy cools off or even slips into a recession. During a recession, demand shrinks, businesses and consumers borrow less, and interest rates fall. But then again, lower interest rates make things more affordable, and businesses and consumers start borrowing more, which eventually brings the economy out of recession and into expansion again. The cycle is complete and repeats.

Federal Reserve Actions

The Federal Reserve has the dual mandate of keeping inflation down and employment up. It knows that lower interest rates stimulate demand; so when the economy goes into a recession, the Federal Reserve starts lowering interest rates to encourage lending and borrowing.

Interest Rate Cycle

Rising and falling interest rates are a complete cycle, each one of a different duration and a different high and low. This is why interest rates are so notoriously hard, if not impossible, to predict, but one thing an investor can be sure of is that a period of rising rates will eventually be followed by a period of falling rates. Rising interest rates precipitate the conditions for their eventual fall, and falling interest rates precipitate the conditions for their eventual rise.

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