The Interest rate is the amount a lender charges a borrower and is a percentage of the principal. It is typically noted on an annual basis known as the annual percentage rate (APR). Interest rates have become one of the most important aspects of economic systems especially in America as they been used to provide insight into the future economic and financial market activities. The basic characteristic of interest rates is when interest rates are rising; both businesses and consumers will cut back on spending. This will cause earnings to descent and stock prices to drop. On the other hand, when interest rates have tumbled significantly, consumers and businesses will increase spending, causing stock prices to upsurge.
Based on historical observation, stock prices and interest rates have generally had an inverse relationship. Said plainly, as interest rates move higher, stock prices tend to move lower. For stocks, it can go either way because a stock’s price depends on both future cash flows to investors and the discount rate they apply to those expected cash flows. When interest rates rise, the discount rate may increase, which in turn could cause the price of the stock to fall.
Raising interest rates makes borrowing money more expensive, which can hurt individuals and businesses. Generally, raising interest rates slows down the economy by discouraging people from spending money. Homes cost more to buy for individuals and borrowing money to finance business operations becomes more costly.
The types of investments that tend to do well as rates rise include:
Banks and other financial institutions. As rates rise, banks can charge higher rates for their mortgages, while moving up the price they pay for deposits much less.
· Value stocks.
· Dividend stocks.
· The S&P 500 index.
· Short-term government bonds.
Factors that influence interest rates
Demand for money:
Typically, in a growing economy, money is in demand. Manufacturing sector companies and industries need to borrow money for their short-term and long-term needs to invest in production activities. Citizens need money as they need to borrow for their homes, buy new cars, and other needs. But when an economy isn’t doing that well, companies avoid borrowing if the demand for their products is low. High inventory is detrimental, so they produce less. In effect, they borrow less, hence less demand for money. Consumers also spend less as a bad economy could result in job losses. Ceteris-paribus, the higher demand for money the higher the interest rates.
Supply of money:
Like any other commodity, if the supply of money increases, other things remaining the same the price of money—interest rate, go down. There are situations wherein the investors do not have attractive avenues and they chase the bonds or deposits. If there is no demand for that money at that moment, then the interest rates go down.
Inflation:
Prices of all goods and commodities are set by taking into account the general price increase in the economy—inflation. Interest rates, which are the price of money, are no exception to this rule. Savers need to be compensated by way of higher interest rates for sacrificing their current consumption motives in a high inflationary scenario. Investors will forgo their current consumption and invest in fixed income investments if they get positive real rate of return. The real rate of return is arrived at by deducting inflation number from the nominal rate of return offered on the bonds and deposits. The idea is to keep the real rate of return positive so that after inflation the saver saves something. That means in high inflation era, the interest rates tend to stay up and vice versa.
Global interest rates and foreign exchange rates:
Integration of economies with the global economy has risen compared to what it was prior to acceptance of globalisation in the 90s. That means the interest rates in the economy must be set in line with global trends in interest rates. If a country wants to attract global capital then the interest rates need to go up if the interest rates are going up globally. There are occasions such as the Lehman Crisis in 2008 when the central bankers across the globe choose to cut interest rates to pull the global economy out of recession. Attractive interest rates bring in capital and support the foreign exchange rate. Tweaks in the interest rates in the economy can be used by a central bank for influencing the exchange rate. A central bank may choose to up the policy rates (repo rate) to indicate higher interest rates in the economy and thereby attract capital from overseas investors.
Central bank:
Reserve Banks of nations chooses to focus on various objectives while preparing their monetary policy. In a boom phase, the central bank may focus to contain inflation and hence may choose to hike interest rates. That curtails the consumption and investments driven by borrowed money. In a recessionary period, the central bank may want to induce growth by incentivising consumption and investments by reducing the interest rates. Central bank’s monetary policy objectives thus influence the interest rates.
As has been the norm when interest rates lower, unemployment rises as companies lay off expensive workers and hire contractors and temporary or part-time workers at lower prices. When wages decline, people can’t pay for things and prices on goods and services are forced down, leading to more unemployment and lower wages. This seemed to be on the contrary during President Trump’s era.
Despite the myriad of scandals and investigations that dogged him, lower interest rates largely worked as GDP grew at a healthy clip, the stock market soared and unemployment rates hit a half-century low, until the coronavirus pandemic gutted the job market. Yet as he leaves after his one-term tenure, President Trump has become the first president since Herbert Hoover during the Great Depression to depart office with fewer jobs in the country than when he entered.
In the last year of Trump’s presidency, the unemployment rate reached a 50-year low of 3.5% in February. The coronavirus pandemic soon walloped the economy, forcing swaths of businesses across the country to close. The unemployment rate skyrocketed to 14.7% in April. It receded to 6.7% as of last month but remains above the level of 4.8% when President Trump took office. One would then wonder whether the build back better will prove otherwise, with interest rates all high, inflation biting, Russia- Ukraine war on loggerheads. The bottom line of proving facts and factors that works are in the arena since Joe Biden undid all the Trump policies and enact the contrary ones, the field is really a control room. The unanswered question is should poor to developing countries have high or lower interest rates for their sluggish economies?
