Interest Rates - All you need to know

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Introduction

Interest rates are one of the most closely monitored variables in an economy. This is because interest rates affect every financial decision we make. Whenever we buy something, we indirectly forgo the interest rate we could have earned had we saved the money instead. The interest rate also influences whether it is the right time to borrow, whether lenders will be willing to lend, as well as the cost of any borrowing you already have.

In this Master Class you will learn:

You can also access a visual summary of the article here.

What does the interest rate represent?

The interest rate is expressed as a percentage and represents:

The opportunity cost of holding money: By holding wealth in cash, you will be losing out on the interest which could have been earned had you, for example, deposited the money into an interest-bearing savings account or invested the money.
The opportunity cost
By spending your money on 'A', your opportunity cost is not spending the money on 'B'. By investing in 'A', your opportunity cost is not investing in 'B'.
of holding €100 in cash for one year is forgoing the opportunity for the €100 to compound to €101.50 in one year’s time in a savings account yielding 1.5% interest.
The rate required to equivalize differently dated cash flows: A cash flow in the future is worth less than a cash flow today. To obtain the present value of a future payment, we can use the interest rate (a.k.a. the discount rate) to reflect the fact that money's value dilutes with time.
If €100 today and €110 in one year are equivalent in value, then €110 - €100 = €10 is the interest compensation required for receiving €110 in one year rather than now. Therefore, the interest rate is €10/€100 = 10%.
The required compensation required by a lender to lend to a borrower, or equivalently, the required obligation for a borrower to compensate a lender for borrowing. The interest can thus be viewed as “the incentive” underlying a contractual obligation between two parties. The interest rate compensates the lender at a future date for a sum lent out today. From the borrower’s perspective, the interest rate gives the borrower access to borrowed funds today in return for a higher future repayment.

For instance, Borrower Bob requires some additional cash and asks Lender Lisa to help him out. Lender Lisa provides Borrower Bob with €100 at an interest rate of 10% per year for 5 years. In five years, Borrower Bob is obliged to repay Lender Lisa the €100 principal plus 5 years of interest at €10. Therefore, the repayment after 5 years will be €150. Lender Lisa is just as happy having €100 today as having €150 in 5 years’ time.

How do interest rates affect me?

The interest rate determines households’ spending, saving and investing decisions. It also influences firms’ appetite to invest and banks’ willingness to lend. The interest rate is also crucial for Government, since it determines how costly its debt servicing will be.

Here is a useful table summarizing how the interest rate affects various agents in different ways:

The interest rate affects...	Why the interest rate is important
Households	Interest rates affect households’ consumption and savings decisions. A higher interest rate will make saving more attractive, while a lower interest rate would encourage spending since the opportunity cost of consumption (i.e. saving) would be low. A lower interest rate encourages households to borrow to finance asset purchases such as cars and houses. Interest rates also influence whether to save or invest. A low interest rate on bank current accounts and fixed-term savings accounts encourages investors to seek higher yielding investments.
Firms	Interest rates affect firms’ decisions to invest. Lower interest rates induce an increased appetite for risk. The interest rate also affects a firm's cost of capital which in turn determines its valuation. A higher interest rate implies that the future cash flows of firms will have a lower value and this reduces its equity price.
Government	Interest rates determine the cost of debt servicing. The interest rate on Government bonds is also a key consideration of foreign investors when deciding whether to park capital in the economy. Lower interest rates also present challenges for funded systems by lowering the returns on savings.
Central Banks	The interest rate is the conventional tool used by the Central Bank to conduct monetary policy. The Central Bank increases the interest rate when there is excessive lending to avoid inflationary pressure, and reduces the interest rate when lending conditions are tight to stimulate the economy.
Banks	Banks' willingness to lend is a function of the initial leverage in the financial system, the riskiness of borrowers, their excess reserves, the spread between the interest rates they charge on loans and the interest rate they need to pay on deposits. The lower the interest rate, the lower banks’ profit margins will be. This lowers their risk appetite, so the less inclined they will be to lend.

What is the difference between the nominal interest rate, the real interest rate and the natural interest rate?

There is no single rate of interest.The interest rates quoted in Central Bank announcements, contractual agreements, official statistics and financial newspapers are called nominal interest rates.

The term nominal means actual or unadjusted. In finance and economics, nominal is taken to mean unadjusted for price changes. This is because in lending agreements, the actual compensation paid to a lender for the borrowed amount is based on the nominal interest rate.

The real interest rate adjusts the nominal interest rate for price changes. It is derived using the Fischer equation, which states that:

r= i - \pi_e

where 'r' is the real interest rate, 'i' is the nominal interest rate and π is expected inflation. Nominal and real rates do not necessarily move together. The real interest rate is the most relevant factor for households and firms when they make their investment and saving decisions.

Finally, the natural interest rate is a fictitious metric used by economists which refers to the interest rate that supports an economy operating at full potential, with stable inflation. This is usually denoted as r*.

In general, when policymakers want to stimulate economic activity, the Central Bank targets an interest rate below r*. This should increase the total demand for money relative to the supply of savings, causing people to spend more which should result in price increases.

Interest rates are lowered by Central Banks when lending conditions are tight

and economic growth shows signs of weakening. Contrarily, interest rates are increased when the economy is showing signs of overheating due to ample lending growth.

Therefore, interest rates are a function of economic growth. If growth is lower due to higher debt levels and a reluctance to lend, then interest rates are likely to go lower.

Why are there so many interest rates?

During my economics and finance classes, I always had difficulty understanding why there were so many different interest rates - one set by Central Banks, another interest rate on bank savings, another interest rate charged on mortgages, bond coupon rates, discount rates – the list goes on!

I was always told by my economics tutors to accept the fact that there existed several interest rates which all move together. That answer was not completely incorrect, since all interest rates revolve around the so called base rate, which is determined by the Central Bank. But I never truly understood interest rates before I decided to do my own deep dive into the several categories which exist:

1. The interest rate charged for overnight usage of excess bank reserves

Every so often, Central Bank officials meet to decide on the target interest rate which commercial banks will charge when they borrow from each other. The target interest rate is decided based on the Central Bank's core objectives to support employment growth and keep inflation stable.

On any given day, people make bank deposits and withdrawals. At the end of the day, banks evaluate their reserve holdings.

Commercial banks are legally required to hold a specific amount of reserves on their balance sheet, depending on their deposit balance. If a commercial bank lends too much or has too much withdrawals, reserves may fall below what is legally required. A reserve deficit at one bank means that another bank has a reserve surplus, or excess reserves. In this case, commercial banks with insufficient reserves on their balance sheet have two options:

Either make up for the reserve deficit by borrowing from the Central Bank or
Take out an overnight loan from other commercial banks.

The latter option is cheaper than borrowing from the Central Bank and is thus, this is generally what banks prefer.

Those banks with insufficient reserves borrow reserves from banks with excess reserves and pay an interest rate on the reserves borrowed. And this is essentially the interest rate for the overnight usage of bank reserves.

In the US, this interbank lending rate is known as the Federal Funds rate, while in Europe it is called the Minimum Bid rate. When this interest rate is lowered, banks will be encouraged to borrow from each other and use the excess reserves to grant more loans.

This interest rate is levied on overnight borrowings between commercial banks. Therefore, it is essentially borrowing with almost instant repayment - therefore, it is a short term interest rate.

2. The interest rate controlled by the Central Bank

As already mentioned above, commercial banks also have a more expensive option of borrowing from the Central Bank when they do not meet their reserve requirements.

However they try to avoid doing so, because this interest rate is higher than the overnight borrowing rate between commercial banks. But let's say a bank gets into trouble. Other banks won’t be willing to lend to it using the interbank rate, so it goes to the lender of last resort: the Central Bank. The Central Bank agrees to fund the borrowing requirements of this troubled bank at a higher interest rate than the interbank rate.

This interest rate serves as a benchmark upon which other interest rates in the economy are based.

In the US, the interest rate set by the Central Bank is called the Discount Rate. In Europe, it is called the Main Refinancing Operations (MRO) rate, while in the UK it is called the Bank Rate. The instant repayment nature underlying this form of borrowing makes the discount rate a short term interest rate.

3. The Prime Interest Rate

The prime rate is a short-term benchmark interest rate granted to banks’ lowest risk borrowers. This interest rate is higher than the interest rate set by Central Banks. Interest rates on all bank loans to more risky borrowers like the general public and businesses are set at a premium over the prime rate.

The prime rate and its derivatives are a function of the Central Bank-set interest rate, but vary depending on the duration of the loan, the type of loan and the riskiness of the borrower.

All market interest rates we encounter, such as credit card rates, the interest rates on student loans, car loans, mortgages are based on the prime rate. If the prime interest rate is 5%, and your credit card charges 20% interest on credit purchases, then this is a 15 percentage point premium.

In the following section, we will see exactly what influences market interest rates are determined.

4. The Interest Rate on Deposits

When you deposit money into your bank account, you are essentially lending the bank your money. A bank deposit is your asset, but the bank's liability.

This illustration shows the personal balance sheet of an individual who has €1000 worth of deposits in a bank account, but also has a loan with the same bank for the equivalent amount.

personal-balance-sheet

In this example, the individual's net worth (assets less liabilities) is equal to zero. Assuming that this individual is the bank's first customer, the corresponding balance sheet of the bank includes a loan of €1000 as an asset, along with the deposit listed under liabilities.

Banks are able to generate a return on the deposits by either making loans or buying assets like bonds and mortgage-backed securities. In return for lending them our money, banks pay us an interest rate for the use of the money deposited.

The interest rate they pay on deposits is lower than the interest rate they charge on loans, and the difference between the two is their profit. Thus, to maximize their profits, banks borrow short and lend long.

Deposits which are highly liquid and instantly redeemable pay the depositor a lower interest rate than what could otherwise have been earned had the deposit been put in a fixed term savings account or a longer term retirement account.

5. The Discount Rate

Do not confuse this with the interest rate the US Central Bank charges to commercial banks for overnight lending.

This discount rate is an interest rate used to equalize different dated cash flows.

It is commonly used in asset valuation, using techniques like Discounted Cash Flow (DCF) analysis

. When valuing an asset like a company, the discount rate should reflect its cost of raising capital. A company can raise finances from two sources:

Owners funds, also known as capital or equity; and/or
Debt;

The cost of capital is a weighted average between the return on capital and the after-tax cost of debt, with the weights being proportional to the ratio of capital and debt raised. The discount rate is thus a function of risk, volatility and the interest rate.

WACC = r_D (1-t) \frac{D}{E+D}+r_E \frac{E}{E+D}

where ‘D’ is total debt, ‘E’ is the total equity (equivalent to the market capitalization (current price per share x total shares outstanding)), ‘r_D’ is the return to lenders, ‘r_E’ is the return to equity providers and ‘t’ is the tax rate.

The rate at which future cash flows are discounted may vary between individuals to reflect their financial state and aversion to risk:

For instance, younger individuals are able to hold investments for a longer duration than an individual approaching retirement. Duration risk is higher for the older individual, who may add a premium to the discount rate to reflect the shorter period of time in which the investment may turn out to generate the required return. By discounting the value of the asset by a higher rate, the elderly investor will depress future cash flows further, meaning that the asset needs to be sold at a heavier discount today for the investment to be worth it.
Similarly, a risk averse individual would discount future cash flows by a higher rate, because the premium required to make the investment worth it needs to be higher.

6. The Bond Coupon Rate

Bonds are debt securities issued by companies or governments to raise capital. They are issued at a nominal (or par) value for a pre-specified date, and when the bond matures, the lender will get back the original value of the bond.

During the period in which the bond is held, the bond issuer will compensate the lender with a series of equal, periodic payments until maturity. This payment is determined using the interest rate (or the coupon rate), which is a percentage of the nominal value of the bond.

The bond coupon rate should not be confused with the bond yield - While the coupon rate on bonds is predetermined and remains fixed throughout the maturity of the bond, the yield for the investor who holds the bond does not necessarily coincide with the interest rate. This is because bond prices may appreciate or depreciate throughout the bond’s maturity period, depending on demand and supply.

Consider a primary dealer who buys a 10 year, 3% coupon bond upon issuance at par value of €1000. Upon issuance, the bond yield equals:
\frac{Coupon}{Price} = \frac{(3 \% \times €1000)}{€1000}=\frac{€30}{€1000}=3\%
The primary dealer then decides to sell the bond on the secondary market a couple of years later (well before the maturity date). The bond price is likely to differ from the par value because of demand and supply dynamics. Assuming that the price at which the primary dealer sells the bond is €1200, then the primary dealer sells the bond at a premium. The yield is equal to:
\frac{Coupon}{Price} = \frac{(3 \% \times €1000)}{€1200}=\frac{€30}{€1200}=2.5\%
The new bond buyer Bob earns a lower yield than the primary dealer earned, because the primary dealer sold the bond to the Bob at a premium.

There also exist a wide range of interest rates for different bonds. This is because bonds have different elements of risk associated with them.

Government bonds are considered to be the safest bonds and therefore pay the lowest interest rate, while high-yield corporate bonds are debt securities of the corporations which are the least financially sound. Moreover, each party that wishes to raise capital can issue bonds of different maturities.

How are interest rates determined?

Short term interest rates are controlled by the Central Bank when they target the overnight interbank interest rate. Longer term interest rates are a function of demand and supply for lending and borrowing at different maturities, which is in turn dependent on the riskiness of the borrower, the type of loan, the duration of the loan, liquidity risk and expected inflation.

While the Central Bank cannot directly control interest rates on longer duration lending, they may do so indirectly using tools such as quantitative easing and yield curve control.

How are short term interest rates determined?

Short term nominal interest rates are determined by the Central Bank depending on economic and financial market conditions.

In fact, the yields on bonds with short-term maturities such as Treasury bills and Treasury notes are highly correlated with the Central Bank target policy rate.

The Central Bank raises the interest rate when...	The Central Bank lowers the interest rate when...
People's demand for money is high, or people's demand to save is low	People's demand for money is low, or people's demand to save is high
Money supply is loose, i.e. banks are lending too much	Money supply is tight, i.e. banks are unwilling to lend
Economy wants to attract foreign capital from abroad since foreign investors receive a higher return	Economy wants to depreciate the currency to make exports more attractive

How are medium and long term interest rates determined?

Interest rates further out into the future are determined by demand for borrowing and the willingness to lend at different maturities.

These interest rates still tend to be indirectly influenced by the short term interest rate set by the Central Bank. This interest rate is based on the prime interest rate, but is set at a premium depending on on the borrower’s risk of default, the type of loan, the duration for which the money is borrowed, expected inflation and liquidity.

In this section, we will delve deeper into each of these determinants.

Default Risk: the interest rate reflects the underlying riskiness of the borrower, which is generally a function of the borrower’s financial position and other idiosyncratic factors such as age.
To illustrate, debt-ridden Dana is likely to be charged a higher interest rate to borrow than what would be charged to Safe Sue, because Dana has more debt than Sue. Similarly, the interest rate charged to ordinary bank customers requesting a loan is higher than the interest rate charged on the loans it grants to its safest business clients. As for bonds, Government bonds are viewed as less risky than corporate bonds, so the latter have a higher interest rate to compensate holders for the additional risk.
Loan Type: Loans can be unsecured or secured. Unsecured loans means that the lending is not backed by any asset. Therefore, if the borrower defaults, the lender ends up with nothing. Therefore, the interest rates on unsecured loans are higher than interest rates on secured lending. This is because secured loans are loans which carry some form of collateral. If the borrower defaults, then the lender at least is able to claim the asset.
For instance, a large monthly purchase at the supermarket paid for using credit is likely to charge a higher interest rate to the borrower than an interest rate on a car loan or a mortgage. This is because in case of default, the lender can claim ownership of the car or the mortgage.
Time: longer term debt obligations tend to have substantially higher risk than shorter term obligations, because of the uncertainty which lies in the future and because the opportunity cost of lending is higher. For instance, the interest rate on short duration bonds is generally lower than the interest rate on longer term bonds.
Liquidity Risk: Liquidity refers to the ease with which an asset can be sold and converted into cash. Interest rates for assets which are less immediately convertible into cash are higher.
For instance, if I decide to sell a house, I am unlikely to find a buyer immediately, because market frictions exist such as the time it takes to find a buyer, show the property to the buyer, have searches conducted, legal proceedings etc.. Similarly, the interest rate on bonds with lower trading volume tend to be higher, because there are less participants buying and selling, so there will be a lower likelihood that the transaction will be processed at the desired price.
Expected Inflation: Inflation erodes the value of non-interest bearing cash. The interest rate thus should reflect the fact that the future repayments on an amount borrowed will have less value because of inflation. When inflation is high, future repayments on loans have lower value. Therefore, inflation favours borrowers, but is less desired by lenders. Bonds tend to be less desirable when the market expects inflation because the fixed periodic coupon payment becomes less valuable. To ensure that the purchasing power of your wealth does not get diluted, the interest rate you receive on your wealth must exceed the rate of inflation.

Given the above factors, the interest rate on medium to long term debt is market driven and can fluctuate depending on demand and supply for lending and borrowing at any given time. In fact, yields on bonds with longer maturities may increase or decrease in accordance to the demand and supply for bonds.

The Yield Curve

The yield curve is a plot of bond maturity against bond yields for a particular borrower.

A borrower can issue debt at various yields. For instance, Governments issue bonds at varying maturities, ranging from 1 month to 30 years. A company can also issue bonds at various maturities, but these tend to be longer dated than Government bonds because the capital is usually tied to investment projects which take time to implement.

The yield curve is generally upward sloping. This means that longer-duration bonds earn lenders higher yields than shorter-duration bonds from the same institution. This makes sense, because shorter duration bonds carry less duration risk, so they yield a lower return.

united-states-yield-curv

united-kingdom-yield-cur

The difference between the yield on short duration bonds and that on long duration bonds is called the yield spread. A widening yield spread may mean one or both of the following:

Investor demand for short term lending is significantly higher than demand for long term lending. Remember that higher demand for bonds increases the price and depresses the yield.
The rate of issuance of longer duration bonds by the borrower is higher than the rate at which short duration bonds are being issued.

The yield curve can also be inverted. This means that investors are so concerned about the short term prospects that they sell their shorter dated bonds and demand longer term bonds. Short term bond prices fall and yields rise to the extent that the yield exceeds the yield on longer dated bonds. An inverted yield curve has sometimes been a precursor to an economic recession, yet this is by no means a necessary condition.

turkey-yield-curve-14-ap

How to determine the trajectory of interest rates?

In the immediate term interest rates are influenced by Central Bank's policy response to economic prospects, but over longer stretches of time, interest rates tend to respond to structural factors which dictate the trajectory of secular inflation, like demographics, productivity and debt. Behavioural factors like risk appetite may cause short term deviations from this long term trajectory.

Let us elaborate on each of these points.

How do demographics affect the interest rate?

On average, people of the same age tend to act in the same way. In general, an economy’s propensity to save depends on the speed of ageing, the average life expectancy and the strength of the labour force.

A rapidly ageing population tends to lead to increased saving in anticipation of retirement. Demographics not only affects the amount of saving, but also the composition of saving. As people age faster, the more there tends to be preference towards less risky assets like bonds, which puts downward pressure on bond yields.
Increases in life expectancy further amplifies the propensity to save, as people hoard their earnings with the hope that they will accumulate enough savings to enjoy their retirement.
Slower labour force growth uncompensated by higher worker productivity reduces output per worker. This leads to a lower demand for investment, and higher savings, which puts downward pressure on interest rates.

How does productivity affect interest rates?

Productivity is defined as output per worker or output per hour. Productivity determines the long-term trajectory of interest rates through two channels:

Wages: wage growth tends to mirror productivity growth. Developed economies have witnessed a steady deceleration in productivity over the past decade. Combined with a significant increase in the workforce as baby boomers landed jobs
According to the theory of diminishing returns, the larger the availability of a factor of production like labour, the lower the cost required to use the factor of production. An abundance of labour means that there will be low wage pressure
, wage growth remained subdued. Lower wages means that individuals will have reduced expected lifetime incomes. Compounded with the profound increases in prices of essential goods (like food) and services (like education and healthcare), households are likely to save more and spend less on non-essential items. As the behavioural propensity to save increases and aggregate consumption declines, there will be downward pressure on prices and hence the natural interest rate. Besides, in light of price increases in essential goods and services, cohorts with the lowest incomes may find it hard to make ends meet using their income. This may lead to an increase in debt. This means that debt repayments will take up a larger portion of disposable income. This means that demand for money to consume will remain subdued, which can lead to downward pressure on the interest rate.
Debt: The long-term debt cycle can shed some light on where secular interest rates are headed, because towards the end of the long-term debt cycle, the gain in productivity for every additional unit of debt is limited. As an economy becomes increasingly dependent on debt for growth, the debt servicing burdens of investment outweigh increases in productivity. In response to this low productivity growth, policymakers reduce interest rates so that borrowers can service their debts at affordable rates. The lower interest rate encourages further leverage and the potential for unproductive investments. And the cycle continues.

productivity

the-long-term-debt-cycle

How does behaviour affect interest rates?

The behaviour of consumers and firms also determine long term interest rates. The more firms retain earnings or use their profits to buy back shares instead of making productive investments, the lower the spending multiplier will be and the lower interest rates will go to incentivize borrowing. An increase in households appetite for precautionary saving and more risk averse investing behaviour means that there will be downward pressure on interest rates.

In fact, the Global Financial Crisis ignited a spirit of risk aversion and a flight to safe assets

as behavioural shifts induced more precautionary saving. If the supply of safe assets like bonds is limited, then an increase in demand for these safe assets will increase the price of these safe assets and reduce the yield. This downward pressure on yields gets amplified further when economic uncertainty prevails. During uncertain periods, market volatility tends to be high, so investors become more risk averse and recalibrate their portfolios towards bonds. This increases the demand for bonds relative to the supply, driving yields downwards.

The reverse occurs when there is excessive supply for safe assets. Case in point, in response to the Covid-19 pandemic the supply of bonds to finance government deficits increased. An increase in supply of bonds relative to demand lowers the price and increases the yield. As economic growth prospects improve, inflation expectations rise, bonds become unattractive because of their fixed income will be diluted by inflation, and the yield increases. This will not bode well for highly indebted economies and companies.

Visual Summary

The following is a visual summary of the salient points discussed above.

Interest Rates - All you need to know - Part 1

Interest Rates - All you need to know - Part2

References

Content

Dalio (2020), The Changing World Order: Why Nations Succeed and Fail
Lee, K.S. and Werner, R.A., 2018. Reconsidering monetary policy: An empirical examination of the relationship between interest rates and nominal GDP growth in the US, UK, Germany and Japan. Ecological Economics, 146, pp.26-34.
Werner, R.A., 2014. Can banks individually create money out of nothing?—The theories and the empirical evidence. International Review of Financial Analysis, 36, pp.1-19.