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Interest rates, while widely circulated, are scarcely understood. What determines interest rates? Why are they important? How do you measure how ‘good’ an interest rate is? In this article, we’ll try to breakdown all this and more – and hopefully, you’ll have a different view of interest rates, their meaning and their function.
Interest rates are probably the most important factor that affects the wealth of individuals and nations alike. And due to how much interest rates move around, it’s understandable why people would take such a keen interest in this number. It has an impact on every person, every business and every single government.
To paint a picture of just how much interest rates move, we’ll look at South Africa’s interest rates. In April 1999, South Africa’s interest rate (repo rate) was at 15.75%. In 2009, it was almost half of that, at 8%. Today, April 2019, interest rates are at 6.75.
South African Interest Rates: April 1999 to April 2019
As you can see, the rate has made some big jumps over the years. But what is behind these moves, and, more importantly, how does it affect our government, the broader economy, and your wallet.
A theoretical look at interest rates
Firstly, it might be helpful to step back and define interest rates. Financialdictionary.net defines interest rate as:
An interest rate is a percentage amount of the whole sum of money, which is either being saved or borrowed. In the case of savings, the saver gets paid either an annual or monthly interest rate amount on the money in their accounts. For borrowers they have to pay either a monthly or annual interest rate on their debt repayment.
Simply put, an interest rate is the cost of money. The rate that guides most markets is known as the repo rate and it is largely determined by the government. The underlying factors – how much people borrow and what lenders are willing to give – determines the direction of the rate. When the number of people looking to borrow more money than what lenders are willing to give out at the current rate, the rate will go up. Accordingly, when fewer people wish to borrow funds, the rate will go down.
While this is a fairly simple concept, the lenders that provide funds want to be paid for their funds being used. That payment must cover inflation and risk. The former is a very close determinant of interest rates. Usually interest rates will be a couple of percentage points* above the prevailing inflation rate.
The latter, risk, covers against the likelihood that borrowers may default on their promise to pay back the loan. When borrowers are considered ‘low risk’ because it’s almost certain they will repay the loan, their interest rate will tend to be lower that borrowers who are more likely to default.
Interest in the real world
In our everyday lives, economies are likely to be growing and thriving when interest rates are low and access to credit is somewhat easy. A low interest rate means money is cheap. Cheap money means that businesses and individuals can take on credit obligations with a lower cost of debt. This encourages consumers and businesses to spend more.
When interest rates are higher, then it’s very likely that times are tough – institutions such as banks will be unlikely to lend money freely, consumers and businesses will be spending a lot less. This can be seen if we contrast economies with high interest rates such as Argentina (67.87%), Venezuela (32.28%) and Turkey (24%) with lower or negative interest rate economies such as the US (2.25%), The European Union (0%) and Japan (-0.1%).
The role of the South African Reserve Bank
Trying to figure out what makes an interest rate “right” is a rather difficult task. That’s where the South African Reserve Bank (SARB) comes in. The SARB is tasked with maintaining price stability by driving the country’s monetary policy through the Monetary Policy Committee. In essence, the SARB’s responsibility can be summarised as safeguarding the value of the South African rand against foreign currencies such as the US dollar by keeping an eye on inflation.
Inflation – the rise in prices and decrease in the purchasing power of money – is what happens when economies are growing. In this scenario, demand increases at a faster rate than supply. This dynamic causes prices to rise. The reverse scenario will cause an opposing effect. The SARB must keep inflation within a certain range. This is known as inflation targeting.
The SARB steps in by adjusting interest rates, raising them so that demand slows down a little and the economy cools down. However, the government must guard against too much cooling. When the government needs to stimulate the economy, then rates will drop to encourage spending.
Interest rates and the stock market
Usually when interest rates go up, media outlets will focus on the impact on household spending. Consumers will suffer because the cost of their home and car loans go up. This means they have less money to spend in other areas. It also means plans to purchase large ticket items are put off for a few months or years or holidays are scaled down or stopped entirely.
Businesses are affected in a similar way. Higher interest rates mean that businesses may delay or pull the plug on expansion projects because the cost of money, credit, is too high or they cannot secure debt funding. In a similar vein, entrepreneurs looking to launch businesses may find themselves unable to do so because credit taps are dry.
The result is that the economy slows down considerably, and with it, company profits. That’s why a glow growing economy will almost always be accompanies by a sluggish or bear market. You’ll also often hear company CEOs point to the slowdown in spending as a large contributing factor to sales growth, for instance.
And, when rates are lowered, you’ll find that all these trends go in the opposite direction.
Because investors in the stock market are looking to the future, they will always try to anticipate the impact that interest rates will have on a company’s earnings and price it into the company share price. In this way, they ‘discount the future’.
When the market anticipates a rise in rates, it tends to reflect in the lower stock prices. This is why investors also look out for inflation – they know that inflation means their portfolios will be impacted. (This is also why a diversified portfolio with offshore exposure is important.)
All in all, it’s important that you as an investor keep track of interest rates and understand how they work. You can find information on Interest rates from news sites such as Bloomberg (https://www.bloomberg.com/quote/SARPRT:IND) and Investing.com (https://za.investing.com/indices/major-indices).