Why do short-term and long-term interest rates - such as the one month and ten year rates - tend to change together?

Answer 1

Interest rates express the value of money over time, and are a function of inflation and supply/demand of capital. In US markets, short-term interest rates - such as the one-month interest rate - are almost wholly dependent on where the Fed Open Markets Committee (FOMC) sets its overnight lending rate, known as "Fed Funds". The FOMC meets about every six weeks to raise or lower interest rates depending on the path of the economy and inflationary/deflationary pressure. For example, after September 11th, the FOMC met to "ease" interest rates (i.e., lower them) to stimulate borrowing and spending. During the tech boom, when the economy was hot and speculation rife, the FOMC was "tightening" money (aka "hiking" rates) by raising its target interest rate and therefore increasing borrowing costs. The FOMC target rate, and expectations for future FOMC rate moves, drive the short end of the yield curve. Long-term interest rates are also responsive to Fed policy, but are more dependent on supply/demand dynamics as well as longer term rate expectations. If, for example, people expect a lot of inflation (i.e., the value of a dollar erodes rapidly over time), long-term interest rates will be high. In recent years, pension investment and overseas demand for USD bonds have kept long-term rates relatively low. Because the FOMC sets interest rates in response to economic and inflationary conditions, and because longer term investment decisions are dependent upon those factors, you tend to see short-term and long-term interest rates move in the same direction.