A Guide to Interest Rates

If you want to borrow money, you will need to pay. This “fee” for temporarily using someone else’s money is called an interest rate.

 

The advantage of borrowing money is that you get instant access to capital, which would have otherwise taken years to accumulate. 

 

Thus, to enjoy the benefits of bringing potential future capital appreciation to the current day, the borrower is required to compensate the lender by incurring costs calculated based on interest rates.

 

 

 

What are Interest Rates?

 

An interest rate represents the expectations of a lender. Usually a fixed annual percentage, which when multiplied by the principal amount of the loan, leads to the calculation of annual interest cost which the borrower must bear. 

 

 

 

Why are Interest Rates Important?

Interest rates are critical to the efficiency of an economy. They determine borrowing patterns and also influence the level of savings. 

 

Central banks around the world usually increase or decrease interest rates to stimulate economic growth and control inflation.

 

Interest rates can be divided into two simple categories, which are:

 

Deposit Interest Rate

  • Most financial institutions, such as banks, NBFCs, and other private lenders need a valid license to accept public deposits and offer attractive deposit interest rates to the savers.
  • Most such investment schemes carry a fixed deposit rate. However, there are also floating rate schemes.
  • Savers park their surplus money with such institutions to earn interest income.

 

Lending Interest Rate:

  • The money garnered from savers and investors is lent to borrowers in the form of loans.
  • These loans carry a fixed or floating lending interest rate, which needs to be paid by the borrowers at fixed intervals of time.
  • Some of the most common loans are car loans, mortgage loans, and personal loans.

 

 

What is the Relationship Between Interest Rates and Inflation?

 

Interest rates are often considered to be the primary tool of the central banks to control the level of inflation.

 

By increasing or decreasing interest rates, central banks can control inflation in the following manner:

 

Interest Rates are Increased to Lower Inflation: 

  • By doing this, “borrowing” becomes expensive. 
  • This ultimately reduces the overall money in circulation in the economy as people borrow less and spend less. 
  • Supply remaining constant lowers the demand for goods and services, which in turn leads to softening prices.

 

Interest Rates are Raised in a Low Inflationary Environment or Depressed Economy:

  • By doing this, “borrowing” becomes cheaper.
  • The borrowers tend to borrow more money at cheaper rates, which ultimately enhances the supply of money in the economy.
  • Supply remaining constant augments demand for goods and services, which in turn leads to an increase in the prices.

 

 

Why were Interest Rates Low for So Long?

Since 2009, interest rates have remained largely depressed in most developed nations.

 

This is a particular phase of the economy wherein the risk-free rate of return (generally represents the interest rate offered by the government securities) is less than the historical average. 

 

This is primarily done to boost the otherwise depressed economy showing signs of low GDP growth and high unemployment. 

 

Several economies lower their lending interest rates to make borrowing cheaper. This prompts several interested parties to borrow money from financial institutions and invest in physical and financial assets. 

 

By lowering the interest rates, an economy can reap the following benefits:

 

Stimulate Economic Growth

  • A low-interest rate regime often experiences a high demand for goods and services
  • There is an increased money supply in the economy, and people even witness an increase in their levels of disposable income
  • The revenue of the business organizations, their profit margins, and even federal tax collections witness a boost

 

Increased Borrowing: 

  • Getting money on interest from financial institutions becomes cheaper and more advantageous.
  • This leads to an overall increase in the quantum of borrowed money, which ultimately circulates within the economy.
  • A decreased lending rate favors business houses, and they often see their profit margins improving

 

 

Why are Interest Rates Rising Now?

In mid-March 2022, the Federal Reserve announced a 250 basis point hike in interest rates—the first time the central bank has raised interest rates in the past three years. 

 

This has happened mainly because inflation touched an excessive level of 8.4% in March 2022,against the federal government’s tolerance limit of 2-3%. Such an increase in interest rates is done to achieve the following objectives:

 

To Tame Hot Inflation

  • The prices are on the rise. 
  • Everything is on a bull run, from grocery items to high-end electronics.

 

To Curb or Restrict Spending: 

  • The extended low-interest-rate environment has boosted the disposable income of consumers to unprecedented levels.
  • With supply remaining essentially constant, this has led to an increase in the prices due to robust demand.

 

 

 

 

How Can Interest Rates Impact Your Trading?

 

In the United States, the FOMC (Federal Open Market Committee) is responsible for reviewing and changing the interest rates prevailing in the economy. Since the US dollar is the de facto world reserve currency, shifts in Federal Reserve monetary policy can have a profound impact on the entire world’s financial system. An increase or decrease in interest rates makes borrowing expensive or cheaper, and that has different implications for consumer and producer nations around the world. 

 

The most obvious and immediate impact is usually seen in the stock market and is visible in the financial statements of such listed companies. Let us now understand the impact of interest rates on:

 

Stock Prices

 

Debt is often considered to be one of the most preferred financing options.

 

An Increase in Interest Rates:

 

  • Leads to an increase in the overall interest cost of the business entities.
  • Prompts them to either cut growth or accept lower profits.
  • Reduces the supply of money in the market and leads to a fall in demand for goods and services.
  • Further dents the profitability companies due to reduced sales
  • Lower stock prices in general

 

 

A Decrease in Interest Rates:

 

  • Leads to an increase in savings.
  • Companies prefer to leverage and decide to expand by investing more money in their business.
  • The supply of money is augmented in the market, which leads to an increase in the demand for goods and services.
  • The sales of the companies increase, and they show a robust profit.
  • Higher stock prices in general

 

Forex

 

Interest rates are vital for forex traders too, because the health of a currency can be gauged by the level of interest rates in that country. 

 

High interest rates also makes Carry Trading very appetizing, whereby income is generated by holding the currency with a higher interest rate, after borrowing a low-interest rate bearing currency.

 

 

 

Conclusion

If you want to bring future expected returns or income to the present day, you will be required to pay interest to your lender, at a percentage known as the interest rate.

 

Central banks around the world periodically review the interest rates prevailing in their countries and increase/decrease them to tame inflation and boost economic growth. 

 

Such a variation in interest rate makes borrowing more expensive or cheaper, which also impacts everything from stock to commodityprices. In most cases, a high interest rate  envinroment leads to a fall in stock prices, whereas a low interest rate envinroment can help to increase prices in the stock market. 

 

 

 

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