What are interest rates really?

I recently had someone ask me to explain what interest rates are.  At first I was stumped, thinking ‘you know, the rate interest', but then it occurred to me that wasn't really the question.  My acquaintance was really asking, "what is the function of interest rates" and are they arbitrary?  Great questions with an interesting answer.

It would be appropriate to start with a definition of interest, so I opened a few old textbooks.  Oddly, none had a definition of interest.  Plenty of more arcane terms regarding interest rates were defined, but not even a basic definition of interest.  I guess we were just expected to know that going in.  Even my 1990 copy of The Wall Street Dictionary had such an error confusing borrower with lender, that the definition was unusable.  Dictionary.com to the rescue! Definition number 14a: "a sum paid or charges for the use of money or for borrowing money".  A-ha, finally a working definition.

So what does this really mean?  Change the word "money" to "car" as in rental car and it becomes more meaningful:  A sum paid or charges for the use of a car or for borrowing a car.  Just as the charge for renting a car is the same as the price of renting a car, interest is the price of borrowing money.

Just like the price of oil, cars, wheat or lawyers, the price of borrowing money varies with supply and demand.  When everyone wants to borrow, interest rates rise; in contrast, when interest rates are low we say "money is cheap".  Inexpensive shoes tempt people to buy new shoes often just as inexpensive oil encouraged us to use it liberally- just like cheap debt made borrowing attractive.  The difference of course, is that you don't have to give back the shoes, but you do have to pay back the loan.

Are rates arbitrary?  Only the rates set by the Fed are arbitrary.  The Fed sets the rate on overnight loans from the Fed directly to banks and sets a target rate for overnight loans from banks to banks.  This is arbitrary in the sense that the "overnight rate" is set by the Fed and not through market operations of supply and demand (although it is set with considerable analysis and forethought).  All other interest rates "float" with banks and lenders competing for business.  In other words, the market determines what rates ought to be.  If Bank A offers home loans at 7.0%, while Bank B across the street offers them at 6.0%, Bank A is going to lose business and lower their rate to better compete, while Bank B will raise its rate because it has enough business.  In doing so, the collective action of lenders set rates.

Next time the headlines say the Fed is expected to lower rates or that rates on corporate bonds have risen, think of it in terms of price.  It may shed new light on the economy to read "corporate bond yields have risen 1.5% in the past 6 months" as "the price of borrowing money for corporations has risen".  This slightly different perspective may help you understand why rates are changing and what is causing the change.