INTEREST RATES: WHAT ARE THEY & WHY DO THEY MATTER?

30 September 2022

An interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal (i.e. the original sum of money borrowed, that the borrower agrees to give back). Essentially, it is the cost of borrowing. The asset borrowed can be in the form of cash, large assets such as a vehicle or building, or just consumer goods. But why is this concept so relevant at the moment? Interest rates are an important tool that central banks use to reduce inflation. Inflation, which is a general increases in prices over time, is currently surpassing target levels at close to 10% in the UK and other developed countries, and is raising the cost of living. This affects the least well off the hardest. To stem inflation, central banks are intervening by raising their interest rates, which in turn raises the cost of borrowing for banks. This ripples down to businesses, potential home buyers and consumers, and dampens demand. As a result, prices cools down, but this increases the risk that the economy slows down too much, and goes into a recession. In this case, companies and thus stock markets perform badly too.

In the US, the central bank, known as "The Fed" has recently raised the The Federal Funds Rate (FFR)- the benchmark US interest rate at which banks lend money to each other overnight - by 0.75 basis points to 3.25%. This is important because it serves as the basis for all other interest rates in the country. When the Federal Reserve wants to encourage economic growth, they lower the FFR. This makes it cheaper for banks to borrow money, which they can then lend to consumers and businesses at lower interest rates.

In the UK, the Bank of England also raised its key interest rate, known as 'the base rate' or Bank Rate, by 0.5 percentage points to 2.25%. The European Central Bank also raised interest rates in September 2022. Changes to countries' interest rates affect the global economy. For example, the FFR in the US affects the global economy in a few ways, as we are seeing in the news at the moment. First, it is a key determinant of the U.S. dollar's value relative to other currencies. A higher FFR makes the dollar more attractive to foreign investors, leading to an appreciation of the dollar. This appreciation can have negative consequences for US exports, as they become more expensive for foreign buyers.