How are interest rates determined in an economy? from Alicia Reno's blog

Interest rates play a crucial role in the economy, influencing everything from individual savings and borrowings to broader economic growth. From earning the best Savings account interest rates in Sri Lanka to USD to LKR conversions when you send money to Sri Lanka, and payments on personal, business and gold loans, interest rates have an impact on all our financial decisions. It is defined as the price of borrowing money, the reward for saving, and a key lever for central banks in managing economic activity.

Understanding how interest rates are determined are essential for grasping the dynamics of an economy. Let’s explore the various factors that influence interest rates, including the role of central banks, market forces, inflation, and the global economy.

The Role of Central Banks

Central banks (like the Central Bank of Sri Lanka) play a pivotal role in determining interest rates in an economy. They are responsible for setting the short-term interest rates at which commercial banks can borrow from them or lend to each other. This rate, often referred to as the policy or benchmark rate, serves as the foundation for all other interest rates in the economy.

Central banks use monetary policy tools to influence interest rates and control economic activity. The primary tools include:

·         Open market operations: Central banks buy or sell government securities in the open market to increase or decrease the money supply. When a central bank buys securities, it injects money into the economy, lowering interest rates. Conversely, selling securities withdraws money from the economy, raising interest rates.

·         Discount rate: The discount rate is the interest rate at which commercial banks can borrow directly from the central bank. By raising or lowering the discount rate, the central bank influences the cost of borrowing for banks, which in turn affects the interest rate they charge their customers.

·         Reserve requirements: Central banks can also influence interest rates by changing the reserve requirements for commercial banks. Higher reserve requirements mean banks have less money to lend, leading to higher interest rates, while lower reserve requirements increase the money available for lending, resulting in lower rates.

Central banks often target a specific inflation rate, usually around 2%, to ensure price stability. If inflation is above the target, the central bank may raise interest rates to cool down the economy, Conversely, if inflation is below the target, they will lower interest rates to stimulate economic activity.

Market Forces

While central banks set the benchmark interest rates, market forces play a significant role in determining interest rates across the economy. These forces include the supply and demand for credit, the level of economic activity, and expectations about future interest rates and inflation.

The supply and demand for credit are fundamental determinants of interest rates. When businesses and consumers demand more credit, interest rates tend to rise as lenders can charge more for loans. However, when the demand for credit is low, interest rates generally fall.

The supply of credit on the other hand, is influenced by the availability of funds from savers and investors. When more people save money, the supply of credit increases, putting downward pressure on interest rates. If savings decline, the supply of credit shrinks, leading to higher rates.

The level of economic activity also affects interest rates. During periods of robust economic growth, demand for credit typically increases as businesses expand and consumers spend more. This heightened demand can drive up interest rates. In contrast, during a recession or economic slowdown, demand for credit decreases, lowering the rates.

Market participants’’ expectations about future interest rates and inflation can also influence current interest rates. If investors and borrowers expect rates to rise in the future, they may lock in current rates, increasing demand for credit and pushing up interest rates. Similarly, if inflation is expected to rise, lenders may demand higher interest rates to compensate for the loss of anticipated purchasing power.

Inflation and Interest Rates

Inflation, the rate at which the general level of prices for goods and services rises, is closely linked to interest rates. Central banks monitor inflation and adjust the interest rates to maintain price stability.

The Fisher Effect is an economic theory that describes the relationship between these two factors. It states that the nominal interest rate is equal to the sum of the real interest rate and the expected inflation rate. In other words, if inflation is expected to increase, nominal interest rates will also rise to maintain the real return on investments.

For example, if the real interest rate is 2% and inflation is expected to be 3%, the nominal interest rate should be around 5%. If inflation expectations change, so will the nominal rate.

Inflationary expectations are also a key determinant of interest rates. If businesses, consumers and investors expect higher inflation in the future, they will demand higher rates to compensate for the decrease in purchasing power. If inflation expectations are low, interest rates will tend to be lower as well.

Global Factors

In today’s interconnected world, global factors also play a significant role in determining interest rates in an economy. These include international capital flows, exchange rates, and global economic conditions.

Interest rates are influenced by the movement of capital across borders. When a country’s interest rates are higher than those in other countries, it can attract foreign investment, leading to an inflow of capital. This increased demand for the domestic currency can lead to an appreciation of the currency and may result in lower interest rates. With capital flowing out, the currency can depreciate and increase interest rates.

Exchange rates, the value of one currency relative to another, also affect these rates. A stronger domestic currency can lead to lower inflation by making imports cheaper, which may allow central banks to keep interest rates lower. On the other hand, a weaker currency can increase inflation by raising the cost of imports, potentially leading to higher interest rates.

Global economic conditions, including economic growth rates, inflation, and interest rates in other countries, can also influence domestic interest rates. For example, if major economies like the United States raise their rates, other countries may follow suit to prevent capital outflows and maintain their currency’s value.

The Yield Curve

The yield curve is a graphical representation of interest rates across different maturities of debt securities, typically government bonds. It provides insights into market expectations for future interest rates and economic conditions.

A normal yield curve slopes upwards, indicating that longer-term interest rates are higher than short-term rates. This is because investors demand a higher yield for tying up their money for a longer period due to the risk associated with time, such as inflation and uncertainty.

An inverted yield curve occurs when short term interest rates are higher than long term rates. This can signal that investors expect lower interest rates in the future, often due to an anticipated economic slowdown or recession. An inverted yield curve is sometimes seen as a predictor of an upcoming recession.

A flat yield curve occurs when short-term and long-term interest rates are close to each other. This can indicate uncertainty in the economy, with investors unsure about future rates and economic growth.

Interest rates are determined by a complex interplay of the above factors. Central banks set the foundation through their monetary policy tools, but the other factors play a significant role in shaping the overall environment. Understanding these factors is essential for making informed decisions about saving, borrowing and investing, as interest rates are a critical component of economic stability and growth.