The topic of interest rates has seen heated and heavy debates in recent months. Forming the core focal point of whole economies, the rate of interest, at its most clarified definition, is the cost of debt for borrowers and the rate of return for lenders of funds. Interest rates are highly dependent on the state of economies and the central bank’s responses to economic and external shocks and fluctuations. In the aftermath of a global pandemic, crippling wars and the collapse of banks since March 2020, interest rates are one of the most closely monitored aspects of national and global economies.
What exactly are interest rates?
Interest rates make up the background of almost all borrowing and lending transactions. At its most basic form, they determine how much money one could expect to gain by lending their money to someone else. They are the key fundamental tool of monetary policy, which in Australia is controlled by the RBA, which sets interest rates on overnight loans in a separate money market. This is also known as the cash rate. Internationally there is the US Federal Funds rate, one of the most influential and monitored rates worldwide due to the connected nature of the global economy.
The Reserve Bank of Australia
Theories also suggest different and intriguing frameworks for interest and cash rates, such as the Keynesian theory of liquidity, which explains the role of interest rate on money demand and supply. This theory defines it as a purely independent, monetary element which strongly influences investment, employment and production. Another such theory is the neoclassical theory, which defines the cash rate as purely economic, created through an individual or agent’s rational choice. The interest rate becomes an independent variable which sketches out relationships between rates and investment productivity or savings. For example, the higher the level of savings, the higher the interest rate, and conversely the lower the level of investment, the higher the rate of return on the investment. Another key connection is between interest rates and an economy’s inflation rate. If a central bank has a larger than usual fear of inflation spikes (money demand greater than money supply), then the greater the risk of investment. This leads to an increase in the price of compensation-seeking investors, leading to higher interest rates, which are wielded to curb the inflation by competing with the rates of return offered by investment.
According to economic theories, the main ways to keep interest rates at optimal, stable levels is government intervention, avoiding extreme deviations, risk management, fiscal policies that generate stability, efficient competition and transparency. However, recent years and external shocks to global economies have seen complete disruption of these stabilizing variables. Interest rates have thus been hiked up by governments globally in order to curb inflation. The primary reason for interest rates’ ability to curb inflation is due to the fact that it makes borrowing more expensive, rendering a strong limit on spending. As discussed above, the risk of investment is now exacerbated.
The current trend of interest rate rises started in early 2021 with a few central banks in Latin America and Central Europe raising their rates to stabilise their currencies and control inflation. Since 2022, the US Federal Reserve has now taken charge in raising interest rates, its Central Bank having been more aggressive in its hikes than other developed economies. With the US Dollar being the most widely-used global currency, this disparity in interest rate rises has affected Australia. Interest rates are a monetary tool that affects the exchange rate, and higher interest rates usually strengthens the local currency against foreign currencies. In pursuit of greater gain, investors are more likely to invest in economies with higher interest rates to achieve higher returns, thus increasing the demand for local currency. However, the Australian Dollar has remained weak as US interest rates have outpaced Australian rates, removing the incentive for investing in Australia. With the Australian Dollar remaining weak, imports become more expensive. At the same time foreign demand for Australian goods increases, driving up prices for both Australian and foreign consumers. Some have highlighted this as a potential issue that could drive global economies into recession, as simultaneous interest rate rises led by the US could lead to countries exacerbating each other’s inflation problem and make controlling inflation harder.
Jeremy Powell, the Chairman for the US Federal Reserve Bank
Forward guidance has also been a key factor in the recent rounds of interest rate rises. This term essentially refers to communications by central banks about the future course of monetary policy; mostly future interest rate changes. During the pandemic, many central banks made promises to sustain low interest rates to encourage borrowing and stimulate the economy when interest rates were near-zero and couldn’t be decreased any further. In 2021 they declared that rates would not rise unless inflation was continuously above target and/or employment was approaching maximum employment levels. Most also estimated that such a scenario wouldn’t materialise until 2023 or 2024. Although central banks began changing their tones in early 2022 when evidence of above-target inflation began to emerge, there were several instances where expectations were not properly set. The earlier estimates were taken by some as promises to not increase rates for several years, which led to markets reacting adversely when they were raised ahead of schedule. In July, the Federal Reserve, European Central Bank and Bank of Canada all had to make rate hikes that were higher than the predicted figures they gave just a month earlier.
It is still far from clear that the rate rises are bringing inflation under control. Although inflation appears to have peaked and is now on a decreasing trend, the measure of core inflation – which tracks volatile items such as food and energy – is still rising.
Interest rates have been a hot conversation topic for its sheer universality. It affects every member within an economy. For consumers, any change by the central monetary authorities has big effects on their disposable incomes. For institutions, insistently increasing rates can have massive effects on their bottom line as less people spend their money, and ultimately in some cases contribute to their downfall.
The recent collapse of Silicon Valley Bank and the shotgun merger by Swiss regulators of UBS and Credit Suisse has seen instability and volatility in financial markets not seen since the Global Financial Crisis. The recent movements in bond yields illustrate this volatility. The 2Y US treasury notes are notoriously stable assets with a historic intra-day trading range of ~5bps per day or 0.05%. In stark contrast to these low figures, these markets have recently seen up to 70bps moves in one period, illustrating the unpredictable nature of interest rates in the near future and current volatility in financial markets.
The first signs of lost control? UBS and Credit Suisse
The recent decision by the Federal Reserve to increase the federal funds rate to 5%, despite fears about global banking stability, give key insights into the thinking of the Fed. By raising the federal funds rate to the highest level since 2007, the board has implicitly maintained that it is strongly committed to returning inflation to its 2% objective. On the other hand, there was an unusually dovish tone, with the Powell conceding that credit is likely to tighten in the coming months.
Currently, the 30-day interbank cash rate futures are pricing in a 91% probability that Phillip Lowe and the RBA will halt rises in their next meeting in April, breaking the streak of 10 consecutive interest rate rises. Some analysts disagree with the CBA and ANZ chief economists calling for a 25bps increase depending on how the monthly consumer Price index, which is released this Friday, changes. The path to a soft landing of stable employment and inflation remains a treacherous one. The next decision by the RBA in April will be instrumental in the macroeconomic forecast for Australia. A pivot too early could lead to runaway inflation the last seen in the 80s. Alternatively, another raise may be the straw that breaks the camel’s back, sending the economy into a spiral and leading to mass unemployment. With major volatility and uncertainty around banking stability globally, overextension may further the strain on many institutions and households around the world.
This upcoming year of monetary policy will be looked upon with historical significance, leading to either another global recession or a textbook master class in macroeconomic stabilisation. How and when the central banks around the world decide to pivot their policies will be instrumental in deciding how many Australians continue to suffer through the cost of living crisis.
Images sourced from Smyth Real Estate, ING Think, The Times, and Reuters
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