According to Bloomberg, 60 Central Banks have hiked rates in 2022. The US Central Bank (the Federal Reserve) has raised rates thrice this year alone. Central banks worldwide have been forced to raise interest rates to curb soaring inflation.
What interest rates are we talking about?
The interest rate commonly referred to when we say the Central bank has raised rates is the rate at which commercial banks borrow and lend cash to other banks in the overnight market. It is called the Federal Funds Rate (FFR) in the US or the Monetary Policy Rate (MPR) in Nigeria.
Commercial banks are required by law to hold a percentage of total deposits in a Central Bank account daily. This is called the reserve requirement. Some banks sometimes cannot meet their reserve requirement because they lent out too much cash, while some other banks have more cash than they need.
The bank with excess cash lends the excess to banks that don’t have enough at a set interest rate. That rate is the FFR in the US or the MPR in Nigeria.
Why is that rate important?
The Federal funds rate or the monetary policy rate forms the basis for the rate banks charge customers. As the FFR and MPR rise, the rate at which banks lend rises. When the MPR was 11.5%, banks could lend at 20%, but now that the MPR has risen to 13%, banks will lend at over 22%.
Why do Central Banks have to raise interest rates when inflation rises?
Short answer: to ensure that government debt remains attractive.
Longer answer:
Nations draw up a budget of their expected revenue and expenses every year. Sometimes they earn more than they spend (a surplus); other times, they spend more than they earn (a deficit). When nations run at a deficit, they can borrow to cover the excess.
They issue debt instruments like bonds to banks, members of the public and other governments to get the money they need. In exchange, they agree to pay a fixed amount in interest at the end of each quarter and the initial amount after some years.
Governments are considered low-risk borrowers because they rarely default on their debt. This feature makes government debt a very attractive investment for many investors.
When inflation starts rising, the fixed amount the government pays their lenders becomes less attractive because the value of money falls as inflation rises. As a result, investors will be forced to sell the debt instruments they own.
When many investors sell debt instruments, this causes the price of government debt to fall and makes government debt unattractive. To maintain the value of government debt, the government increases interest rates.
What Happens when Central Banks raise rates?
Borrowing becomes more expensive
Personal loans, business loans, mortgages, credit cards and other forms of borrowing become more expensive as banks charge a higher interest rate. This should cause spending to reduce and, in turn, reduce inflation.
Savings accounts offer higher interest rates
Savings accounts should offer higher interest rates because the banks are now earning more interest from lending the deposits they hold on behalf of customers. If banks offer higher interest on savings, customers will be more likely to save their money than spend. As customers spend less, inflation should reduce.
It’s worth noting that banks don’t always increase interest on savings accounts as interest rates rise.
Fixed income instruments pay higher interest
Newly issued fixed income instruments like bonds and treasury bills offer the new, higher interest rate, thus making them more attractive. Older bonds and treasury bills still offer the old interest rate, making them less attractive and causing their prices to fall.
Risky assets suffer
As banks raise interest rates, real estate developers have to pay higher interest to borrow and build. Demand for real estate also takes a hit because mortgages become more expensive. This causes real estate prices to reduce.
Companies borrow less when interest rates rise. Less borrowing means less capital is available to companies. Companies with less capital tend to grow less. Lower growth potential reduces the future value of companies. Share prices fall as the future value of companies falls.
As government bonds become more attractive due to the higher interest rates, investors move from risky assets like stocks and crypto to government bonds. As more people sell their risky assets, the price of those assets falls.
Inflation Falls
If everything works as planned, inflation should reduce, and the value of money should increase in the long term. If inflation remains persistent, the Central Bank will be forced to raise rates higher which could cause a recession.
Conclusion
While the news of higher interest rates can seem alarming, it’s not always bad. Higher interest rates make fixed-income instruments more attractive. This presents an opportunity to diversify into lower-risk instruments at a better rate.
Ultimately, higher interest rates seek to bring inflation under control. A steady inflation rate is more beneficial for the economy than soaring inflation.