Why Are Bank Interest Rates So Low?

Bank interest rates, which affect how much you earn on savings and pay on loans, are a frequent topic of discussion. These rates influence returns on savings accounts or Certificates of Deposit (CDs), and the cost of mortgages, auto loans, or credit cards. Many consumers notice these rates often remain low, prompting questions about underlying economic dynamics. This article explores the primary economic forces contributing to low bank interest rates.

The Central Bank’s Influence

The Federal Reserve, the U.S. central bank, significantly influences interest rates through its monetary policy. The Federal Open Market Committee (FOMC) sets a target range for the federal funds rate, the rate banks charge each other for overnight loans. This benchmark rate forms the foundation for interest rates across the economy.

When the Federal Reserve lowers the federal funds rate, it becomes cheaper for commercial banks to borrow. This reduces their lending costs, encouraging them to offer lower interest rates on consumer and business loans like mortgages and auto loans, stimulating economic activity. Conversely, raising the federal funds rate makes borrowing more expensive for banks, leading them to increase rates for consumers and businesses. This action often slows an overheated economy or combats inflation. The federal funds rate directly impacts short-term rates on credit cards and adjustable-rate loans, and can also influence longer-term rates.

Beyond rate adjustments, the Federal Reserve uses quantitative easing (QE) during economic weakness or near-zero interest rates. QE involves the central bank buying government bonds and other financial assets from commercial banks. This injects liquidity into the banking system, increasing bank reserves and further reducing long-term interest rates. By lowering long-term yields, QE aims to make borrowing cheaper for businesses and consumers, encouraging investment and spending to stimulate growth.

The Role of Inflation

Inflation, the general increase in prices over time, fundamentally determines interest rate levels. When inflation is low or stable, central banks can maintain lower interest rates without risking price instability. Low inflation means money’s purchasing power erodes slowly, so lenders don’t need significantly higher nominal rates for a positive real return. A “real” return accounts for inflation, reflecting the true increase in purchasing power.

Lenders aim for a real return on their loans, meaning they want to earn more than the inflation rate. If inflation is minimal, a low nominal interest rate can still provide a satisfactory real return. For example, if inflation is 1% and a savings account offers 2% interest, the real return is 1%. If inflation rises to 5%, the same 2% interest rate would result in a negative real return, as money’s purchasing power decreases.

During high inflation, central banks often raise interest rates to curb spending and control price increases. Higher rates make borrowing more expensive, slowing demand and reducing inflationary pressures. Lenders also demand higher nominal rates to compensate for faster erosion of money’s value. The Federal Reserve targets around 2% inflation, considered healthy for economic growth and price stability.

Broader Economic Conditions

Overall economic health significantly influences bank interest rates, separate from central bank actions or inflation. During slow growth or uncertainty, businesses and consumers reduce borrowing and investment. This reduced loan demand means banks have surplus capital, pressuring interest rates downward. For instance, if fewer businesses expand or individuals seek loans, banks compete by offering lower rates.

An abundance of savings, or a “savings glut,” also contributes to lower interest rates. When the supply of available capital from savings exceeds borrowing demand, the “price” of capital—the interest rate—tends to fall. This reflects supply and demand in the credit market. A significant supply of funds seeking investment, coupled with low borrowing demand, naturally pushes interest rates lower.

Economic stagnation or recession exacerbates these trends. Businesses delay investment and consumers reduce spending, decreasing the overall need for borrowing. This contributes to a persistent environment of low interest rates. The interplay between capital supply and credit demand shapes the interest rate landscape.

Global Economic Trends

Global economic interconnectedness means international trends pressure domestic interest rates. A “global savings glut” suggests excess savings in certain countries, particularly Asia and oil-producing nations, have flowed into global financial markets. This surplus capital seeking investment worldwide contributes to lower interest rates, even in the U.S.

Foreign investors seeking safe investments often turn to U.S. government bonds, like Treasury securities. Increased demand for these bonds drives up their prices and pushes down their yields. Since Treasury yields benchmark many U.S. interest rates, this influx of foreign capital indirectly lowers domestic borrowing costs, including mortgage rates.

Monetary policies of other major economies also play a role. If foreign central banks maintain low interest rates, capital may flow into the U.S. for higher yields, further influencing U.S. rates. This global capital flow means domestic interest rates are shaped by worldwide financial decisions and policies, not solely internal conditions.