McKinsey&Company

Interest rates, which have been so low for so long that US consumers and businesses have come to consider it an entitlement, are starting to creep upward, prompting new concerns and debates. Will higher rates undercut the economic recovery? Should the Federal Reserve do more to hold rates down, or did the central bank already err by leaving them low for too long, feeding the housing and credit bubbles of recent years? It’s worth dispelling some of the most common misconceptions about interest rates.

1. The Fed controls interest rates.
   Yes, the Federal Reserve can change its federal funds rate—the overnight rate charged on loans between banks—and those shifts affect short-term rates on business loans and consumer loans. But long-term interest rates, such as those on a ten-year Treasury bond or a 30-year mortgage, are determined by the markets and influenced by inflation trends, government budget deficits, and the overall demand for and supply of capital over time. The limits of the Fed’s powers were apparent recently when it began its second round of “quantitative easing,” an effort to lower long-term rates by pumping more money into the economy. Those rates did fall in the weeks leading up to the program’s launch in November, but they rose sharply soon afterward. Why? First, signs of a strengthening economy prompted many analysts to raise their growth forecasts for this year, implying that the demand for capital will rise as well—and greater demand for capital translates into higher rates. Second, the tax-cut deal that the White House and congressional leaders struck in December will boost government borrowing this year, adding to the demand for capital. Finally, some investors worry that, as the economy gains momentum, the Fed’s program could lead to rising inflation, and such fears could lead to higher interest rates.

Five myths about US interest rates