LondonFinance1
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Management Consulting
You will have seen “base rate interest rate” hikes quite a bit in the news in the last couple of months https://www.theguardian.com/business/2023/mar/23/bank-of-england-raises-uk-interest-rates-inflation , so it is worthwhile looking a bit deeper into what it is, how it works and what it means for the economy and also for individuals/consumers.
In its simplest term it is the rate a central bank, e.g. as the Bank of England or the US Federal Reserve will charge banks (and other financial services company) for loans. It is usually set by a committee of experts that meets regularly, usually every four to six weeks, which published its decisions immediately after it has been taken https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/march-2023. In the UK it is called the Monetary Policy Committee (MPC) which sets the Bank Rate. It also looks after other interest rates, e.g. the repo rate monetary policy instruments such as open market operation (buying/selling of currency, bonds or other assets) or minimum reserve requirements (deposits that banks are required to hold with the central bank). Most central banks are run independent, but have targets set by their governments – the European Central Banks’ target is to maintain price stability to preserve the purchasing power of the euro. Currently, this is set at 2% inflation over the medium term https://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html This also helps to give some guidance to outside observers (or “the market”) on which interest rate levels to expect from the committees.
Banks are expected to pass on changes in base rates to their customers – in the end, they make money like any other business: buy low, sell high. You might guess which interest rate movements will get passed on quicker to consumers, but overall interest rates for loans, deposits, credit cards and lots of other products will be amended after an interest rate decision. You might have received one of those letters or emails that no one really reads, informing you about changes in the interest rate applied to your account.
Borrowing money will become more expensive which has a dampening effect of investment and spending to reduce inflation. It is a tricky balance for central banks, raise interest rates too high and you will risk pushing an economy into recession, not doing enough can create inflation. You could also make the argument that the current drivers for inflation (e.g. energy cost) are outside the sphere of influence of a central bank, so it can only cure the symptoms. If the cure includes substantial investments, e.g. into green energy, higher interest rates might be counterproductive.
Higher interest rates attract more savings/deposits which offers banks the opportunity to refinance themselves on the market rather than through the central bank.
On a technical level, you will apply a higher discount rate when calculating the net present value of an investment or a project. That means that their present value will be smaller compared to an environment with lower (or even zero) interest rates.
Interest raises mean that mortgages get more expensive - house prices tend to fall if interest rates go up. Interest rates will take up a higher proportion of a fixed housing budget, so there is less money to spend on the purchase of the property itself. It might also mean that marginal buyers are dropping out of the market, so there is less demand overall, driving down prices.
Share prices tend to fall when interest rates raise as cost of capital go up, so it will become more difficult/expensive for companies to finance growth projects. It also means that revenues are predicted to go down as other companies/consumers will have to reduce their spending as well as they need to pay more for finance. Higher interest rates also mean future discounted valuations are lower as the discount rate used for future cash flow is higher. That is not true across the board, though. Not surprisingly, shares of financial services companies tend to raise as their profits are thought to go up; as consumers are thought to reduce spending, discounters/budget companies are thought to fare better as well.
Bond prices tend to fall when interest rates rise. It seems counterintuitive, but if you look at issued bonds with a fixed coupon (regular interest payment), you will see that their overall value will fall when calculated with a higher discount rate. New bonds will carry higher interest payments and will be thus more attractive to investors.
An increase in the interest rate reduces firms' demand for holding inventories (as they become more expensive with a higher discount rate) and therefore lowers the commodity price. As customers are expected to lower their demand, companies might also plan to reduce their output, requiring smaller inventories. On the other hand, the inflation that triggered interest rate hikes will also increase the prices of certain commodities, e.g. oil.
Venture capital and tech investments will suffer, too. Their NPV will be lower, making investments less attractive, especially when compared to alternatives. Their NPV will be lower, making investments less attractive, especially when compared to alternatives. If boring government bonds or bank deposits offer 3% or even more, you might not go for that risky start-up investment, especially if you are a pensions fund.
Pensions should fare better as higher interest rates mean that pay-outs from annuities will be higher and pension providers will achieve higher returns, but NPVs of pensions will be lower.
Crypto with its wild swings is an interesting story in itself. Higher interest rates tend to lower crypto prices since much of this retail speculation is traded on margin and/or disposable income which will be reduced by higher interest rates.
Note that all of the above describes overall trends and single assets can perform better in periods of high interest rates. Some of these trends can also be interdependent. The outcome will also depend on how long this period of high interest rates will last. Short-term interest rates at the moment are higher than long-term rates https://www.statista.com/statistics/1058454/yield-curve-usa/ (an inverted yield curve), so there is some expectation on the market that interest rates will plateau soon https://data.oecd.org/interest/short-term-interest-rates-forecast.htm and might fall again in the not-so-distant future. As ever, look at real interest rates (i.e. take inflation rates into account) for analyses and decision making. While a base rate of 4% and above makes interesting headlines, going back to levels not seen for 15 years, current inflation rates are even higher, especially in the UK, so interest rates might not be that shocking after all.
In its simplest term it is the rate a central bank, e.g. as the Bank of England or the US Federal Reserve will charge banks (and other financial services company) for loans. It is usually set by a committee of experts that meets regularly, usually every four to six weeks, which published its decisions immediately after it has been taken https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/march-2023. In the UK it is called the Monetary Policy Committee (MPC) which sets the Bank Rate. It also looks after other interest rates, e.g. the repo rate monetary policy instruments such as open market operation (buying/selling of currency, bonds or other assets) or minimum reserve requirements (deposits that banks are required to hold with the central bank). Most central banks are run independent, but have targets set by their governments – the European Central Banks’ target is to maintain price stability to preserve the purchasing power of the euro. Currently, this is set at 2% inflation over the medium term https://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html This also helps to give some guidance to outside observers (or “the market”) on which interest rate levels to expect from the committees.
Banks are expected to pass on changes in base rates to their customers – in the end, they make money like any other business: buy low, sell high. You might guess which interest rate movements will get passed on quicker to consumers, but overall interest rates for loans, deposits, credit cards and lots of other products will be amended after an interest rate decision. You might have received one of those letters or emails that no one really reads, informing you about changes in the interest rate applied to your account.
Borrowing money will become more expensive which has a dampening effect of investment and spending to reduce inflation. It is a tricky balance for central banks, raise interest rates too high and you will risk pushing an economy into recession, not doing enough can create inflation. You could also make the argument that the current drivers for inflation (e.g. energy cost) are outside the sphere of influence of a central bank, so it can only cure the symptoms. If the cure includes substantial investments, e.g. into green energy, higher interest rates might be counterproductive.
Higher interest rates attract more savings/deposits which offers banks the opportunity to refinance themselves on the market rather than through the central bank.
On a technical level, you will apply a higher discount rate when calculating the net present value of an investment or a project. That means that their present value will be smaller compared to an environment with lower (or even zero) interest rates.
Interest raises mean that mortgages get more expensive - house prices tend to fall if interest rates go up. Interest rates will take up a higher proportion of a fixed housing budget, so there is less money to spend on the purchase of the property itself. It might also mean that marginal buyers are dropping out of the market, so there is less demand overall, driving down prices.
Share prices tend to fall when interest rates raise as cost of capital go up, so it will become more difficult/expensive for companies to finance growth projects. It also means that revenues are predicted to go down as other companies/consumers will have to reduce their spending as well as they need to pay more for finance. Higher interest rates also mean future discounted valuations are lower as the discount rate used for future cash flow is higher. That is not true across the board, though. Not surprisingly, shares of financial services companies tend to raise as their profits are thought to go up; as consumers are thought to reduce spending, discounters/budget companies are thought to fare better as well.
Bond prices tend to fall when interest rates rise. It seems counterintuitive, but if you look at issued bonds with a fixed coupon (regular interest payment), you will see that their overall value will fall when calculated with a higher discount rate. New bonds will carry higher interest payments and will be thus more attractive to investors.
An increase in the interest rate reduces firms' demand for holding inventories (as they become more expensive with a higher discount rate) and therefore lowers the commodity price. As customers are expected to lower their demand, companies might also plan to reduce their output, requiring smaller inventories. On the other hand, the inflation that triggered interest rate hikes will also increase the prices of certain commodities, e.g. oil.
Venture capital and tech investments will suffer, too. Their NPV will be lower, making investments less attractive, especially when compared to alternatives. Their NPV will be lower, making investments less attractive, especially when compared to alternatives. If boring government bonds or bank deposits offer 3% or even more, you might not go for that risky start-up investment, especially if you are a pensions fund.
Pensions should fare better as higher interest rates mean that pay-outs from annuities will be higher and pension providers will achieve higher returns, but NPVs of pensions will be lower.
Crypto with its wild swings is an interesting story in itself. Higher interest rates tend to lower crypto prices since much of this retail speculation is traded on margin and/or disposable income which will be reduced by higher interest rates.
Note that all of the above describes overall trends and single assets can perform better in periods of high interest rates. Some of these trends can also be interdependent. The outcome will also depend on how long this period of high interest rates will last. Short-term interest rates at the moment are higher than long-term rates https://www.statista.com/statistics/1058454/yield-curve-usa/ (an inverted yield curve), so there is some expectation on the market that interest rates will plateau soon https://data.oecd.org/interest/short-term-interest-rates-forecast.htm and might fall again in the not-so-distant future. As ever, look at real interest rates (i.e. take inflation rates into account) for analyses and decision making. While a base rate of 4% and above makes interesting headlines, going back to levels not seen for 15 years, current inflation rates are even higher, especially in the UK, so interest rates might not be that shocking after all.