- Central Bank – A Central Bank is a nationalized lender who is responsible for issuing currency and credit within a country. In many cases, these Central Banks are pseudo-governmental organisations. They act independently but are heavily regulated and many times rely on political appointments to fill key positions within their leadership team. The core objective of these banks is to promote sustainable growth during economic booms and mitigate turmoil during economic slowdowns. In Singapore, the Central Bank is the Monetary Authority of Singapore (MAS). In the United States, the Central Bank is the Federal Reserve. The Central Bank of the European Union is, the creatively titled, European Central Bank.
- Discount Rate – Large banks are required to maintain certain cash reserves relative to the amount of outstanding loans they have lent out. When these cash reserves fall short of these capital requirements, banks have to request the funds from their country’s Central Bank in the form of a short-term loan. If DBS Bank is short of their capital requirements at the close of the business day, they would call the MAS and request to borrow some funds. The rate charged on this loan is called the discount rate, and Central Banks charge this rate to all large banks for overnight loans within their home country.
- Interest Rate – This is the rate a lender charges when supplying money on a loan. This is expressed in percentage points and will vary based on the size of the loan, the credit-worthiness of the borrower and the overall interest rate environment.
How The Central Bank Influences All Interest Rates Within a Country
In our previous example, we considered the case of DBS Bank requesting overnight funds from the MAS. Let’s assume that MAS raises their discount rate by 1%. When this occurs, DBS Bank has two options:
- Keep the interest rate they charge to customers unchanged and absorb the 1% increase of the discount rate.
- Raise the interest rate they charge to costumers by 1% to compensate for the 1% increase to the discount rate.
In order to protect margins and the current interest rate environment, the majority of banks will take the second approach. This example is an over simplification, but it does a nice job of illustrating how the discount rate established by the Central Bank reaches consumers. As interest rates rise, consumers have less incentive to borrow (borrowing is now more expensive) and more incentive to save (the bank now pays more interest on deposits). This concept gets to the core of our discussion: Central Banks modify interest rates in an effort to either slow down, or kick-start economic growth.
The Monetary Authority of Singapore is an outlier in this approach, as they rely on exchange rates to regulate economic growth. We’ve detailed how this strategy works here. Let’s stay focused on interest rates for this article as this is how the majority of developed nation’s move markets.
Interest Rates – A Global Perspective
Where are interest rates today? Globally, we are seeing some of the lowest rates in recorded history. In Germany interest rates haven’t been this low since the black plague and have actually turned negative. The reason? Central bankers around the world have been in a “race to the bottom” since the 2008 financial crises. This decline has been a continuation of a global interest rate decline since the 1980’s.
These policy makers have been pushing rates lower for two reasons:
- Just as higher interest rates tend to incentive savings and slow down debt-fueled growth, lower interest rates do just the opposite. Central bankers have lowered rates globally in order to incentivize spending and fuel debt driven growth and investment.
- Currency de-valuation: This may sound counter-intuitive, but central bankers have been working to devalue their home currencies. This is done to encourage the export of goods and services. We will explore the foreign exchange component of Central Bank policy in future articles. For now, let’s stay focused on interest rates.
With interest rates near zero in most of the developed world – rates will have a hard time going much lower.
Many interest rate observers are looking for global rates to begin increasing in 2017 as a number of key Central Banks will be looking to raise rate to more historically average levels. This is because many Central Banks are worried about bubbles forming in the economy, like in the stock markets, and want to reign in speculative market behaviors. For instance, low interest rates have encouraged many investors to put money out of the bond market into the stock market, causing S&P500 to reach record high levels despite sluggish economic growth globally. When rates increase, consumers will see the cost of borrowing increase when looking for a student, home or auto loan. On the same token, consumers will see the rate of interest they receive from banks increase. If you expect to need a loan in the coming years, now is the time to investigate personal loan rates.
This article originally appeared on ValuePenguin