We have covered a lot of basic economic ground over the last few months. We have looked at Gross Domestic Product (GDP), Employment, Inflation, Currencies and Credit ratings. This month we will touch on two more fundamental economic items which are key to building a strong “what does it mean” base and these are interest rates and oil.
In today’s edition we will look at interest rates. In its basic form an interest is an amount that a borrower pays to compensate a lender on the risk of giving the former their money. The interest rate is the amount paid by the borrower expressed as a percentage of the borrowed amount. There are many variants of interest rates you will come across in your interaction with the economy, however the main ones that you should be aware of are:
- The Central Bank Rate
- The Interbank Rate and
- The Libor (London Interbank Offer Rate)
In most countries in the world, you will have a central bank or federal reserve as in the United States of America. The main purpose of this institution is to maintain a certain level of inflation and or employment which they do by controlling interest rates in the economy. A Central Bank controls interest by first setting a target interest rate which is called the central bank rate which becomes the rate which determines other interest rates in the economy. The target interest rate then determines your personal borrowing rate on your loans, mortgage rates and to an extent government bond rates.
When a Central Bank meets through their monetary committee, they will either raise, keep, or reduce the Central Bank rate. The impact of an increased Central Bank rate is that commercial banks will revise their lending rates upwards, making borrowing expensive in the economy. The impact of this is a reduction in economic expansion as borrowing becomes expensive, businesses will reduce new investments, and citizens will not consume, and the housing market will contract. If the Central Bank rate is reduced, the opposite will happen. Banks will lower their lending rates making it cheaper to borrow, businesses will increase their investments, and consumption will rise leading to increased economic expansion. An increase or decrease in the Central Bank (CB) rate has an impact on a country’s exchange rate. Ideally when the CB rate goes up, the currency will strengthen albeit with a lag, and if it is reduced the currency will weaken. Therefore, be on the lookout for central bank rate news as it affects you in the ways stated above.
Below is a schedule of the main central banks, whose actions affect the strength of the US dollar. it therefore is key to know what they are saying as we mentioned in the earlier blog on currency
The interbank rate, is the rate which banks lend to each other overnight, for example Standard Chartered bank lending to Barclays bank. Banks lend from each other to cover short term liquidity needs and to avoid borrowing from the central bank. This rate is key because it helps you understand two elements: how liquid the banks are and the rate a bank will be willing to pay for deposits. The combination of the former and latter will affect the rate at which banks are willing to lend at. Currently interbank rates range between 3% – 5% in Kenya. A high interbank rate signifies that there is not enough liquidity in the banking sector and there will therefore be willing to pay more for your deposit, information on interbank rates helps to determine the best time to invest in fixed deposits and government securities. When there is low interbank liquidity, signified by high interbank rates, interest rates will increase offering good opportunities for high fixed income investment returns.
Finally Libor is the interest rate which global banks borrow from each other in the international interbank market. The rate is administered by the Intercontinental Exchange, which asks several major banks at what rate they would lend to each other short term and come up with an average rate which is called the Libor. The rate acts as a benchmark for short term rates and is then used to price various debt instruments, credit cards, student loans, and government debt. How it works and its impact is similar to the central bank rate. Its main impact is on flow of funds between debt instruments and equity instruments. If the Libor goes up, money will flow to fixed income securities, as the returns will be higher than equities.
This is what interest rates news means to you. Armed with the above knowledge you can then make the appropriate investment or borrowing decisions.