What Are Interest Rates?

Interest rates can be defined as a percentage fee for a specific amount that we borrow. The value of the interest rate is measured in percentage and is generally expressed in annual terms. That is, if the one-year interest rates are at 1%, in a given financial transaction, the person or entity that borrows must return the nominal plus 1% at the end of the transaction, while the issuer of the loan (generally a bank or some other financial institution) will receive the face plus interest. For the borrower, the interest rate equals the cost of capital, while for the lender, the interest rate equals the return on the transaction.

Who decides the interest rate levels?

Although not all interest rates in all countries are decided in the same way, the pattern is practically the same in most developed economies. The Central Bank, depending on the economic magnitudes of each moment and mainly through open market operations, decides what is called the official interest rate. From this point on, and despite the fact that the interest rate for each operation is generally determined by the supply and demand of money, all the magnitudes are based on the official central bank rate and move in parallel with the same. From the official rates of the central banks, figures such as Euribor, Libor, Eonia are extracted, and the variations in the cost of capital of the companies are explained.

How often do official interest rates change?

Although each Central Bank is different, the monetary authorities usually meet between 6 and 10 times each year to report on changes in official interest rates. This is not to say, far from it, that there are so many changes in interest rates. Some examples are the action of the United States Federal Reserve, which kept fixed interest rates at a minimum from December 2008 to December 2015, or the Bank of Japan, which kept rates at 0.10% since October 2010.

On the other hand, and although it is not usual in the great powers, the Central Banks reserve the right to urgently change the monetary rates at the time they deem appropriate if the economic situation of the country requires it. This phenomenon has been common in recent years in Brazil, where we have had surprise rate hikes to combat inflation, or in China, where sudden changes in interest rates by the monetary authorities were due to an interest in maintaining the rate. 

What is the objective of the central bank when it comes to changing official interest rates?

Although the magnitudes that Central Banks pursue are not usually uniform, in essence they are not too different. In general, Central Banks will seek to lower rates in times of crisis to reactivate the economy, while they will raise interest rates in times of economic boom in order to lower prices to cool the economy and avoid the appearance of bubbles.

If we stick to more quantitative terms, the objectives are ostensibly different depending on the monetary authority analysed. For example, the European Central Bank's primary objective is to stabilise prices, always seeking positive but sustainable inflation around 2%, while the objective of maintaining employment is subordinate to the former.

Who benefits from a rise in interest rates?

A rise in interest rates makes money more expensive. Therefore, and everything else being constant, an increase in interest rates benefits savers and lenders. After an interest rate hike, lending money to a company, buying government or corporate bonds or simply purchasing any savings product that offers fixed remuneration linked to interest rates become more attractive. On the contrary, companies that seek financing, retailers that have a variable rate mortgage (or those that wish to take a mortgage) become the most affected. In general, interest rate hikes encourage saving while hurting investment.

Who benefits from a fall in interest rates?

Unlike an interest rate hike, falls in the price of money penalise saving and encourage investment. After events of this nature, the agents that benefit the most are the companies that are seeking financing, the states that are preparing to issue new bonds, as well as the consumers that are preparing to take out loans or mortgages. Within this last group, consumers who already have a mortgage and that this is referenced to variable rates will also benefit. On the contrary, all those who have a significant savings base will be harmed, since the income from financial capital will become lower.

How do changes in interest rates affect financial markets?

The markets are not oblivious to changes in interest rates and expectations about them. From an equity point of view, higher rates increase the cost of capital for companies, making the valuation lower while everything else is constant. It is not surprising, therefore, that increases in interest rates are accompanied by falls in equities.

It is in the foreign exchange market where interest rates have their most immediate effect. A currency whose economy experiences an increase in interest rates will become more attractive to investors and will have greater inflows of capital flows. On the contrary, investors will leave in droves of those currencies that have a drop in interest rates. This phenomenon is typical of the foreign exchange market and is called the “carry trade”. 

International capital flows to a greater extent in favor of economies whose currencies present higher interest rates, with inflation constant.

Finally, fixed income securities fall when interest rate rises occur. This is due to the fact that the increases in interest rates make the bonds or other titles of next issue become more attractive because they present a higher coupon. In a search for efficiency, "old" bonds become less attractive, causing investors to exit and, consequently, fall in their price.

Likewise, bonds, debentures, and other fixed-income securities experience price increases the moment interest rates fall. The "old" bonds become more attractive and investors position themselves more strongly. For that reason, bonds are said to respond inversely to changes in interest rates.