Busting Some Interest Rate Myths!

Whenever there is an exchange of value between two parties, one of the main factors of concern would be the ‘benefit expected’ by the giver from the receiver. This expected benefit can be seen everywhere in our daily lives. In the modern financial world, this benefit is found in different forms like dividends, returns, rates etc. The history of compound interest rates dates back to the early 2400 BC and was known as ‘riba’ among early Muslims. Today, interest rates have become an important metric in any economy. Even though interest rates may seem to appear as just a simple value, there are complex processes to set these rates inside an economic boundary. Let us break down interest rates in the remaining part of the essay, keep reading!

Interest rates affect every member in an economy some way or the other. All private and public project valuations are arrived using and opportunity cost, which in most cases are the same or a form of interest rates that are set by the central bank in an economy.

Interest rates for various projects and financial instruments can be broken into:

Real Interest Rate: It’s known as the real risk free rate. Mostly, this is the same as base rate set by the central bank.

Default Risk Premium (DRP): This is the premium paid to the giver for the risk of possible default by the receiver in the future. 

Liquidity Premium (LP): This is the premium paid to the giver for the risk he is taking for the illiquidity of his credit given to the receiver. 

Maturity Risk Premium (MRP): A premium charged to compensate the risk arising from possibility of adverse movements in interest rates that might cause capital losses. 

Inflation Premium (IP): A premium paid to suffice the expected inflation that investors add to real risk free rate of return.

These factors that are added to the real interest rate, varies with different financial instruments. Interest rates are one of the closely watched variables in the economy. Now let’s bust some myths about these interest rates.

Myth #1: Central Banks control interest rates: Yes, to some extent, they do. Central Bank determines the overnight rates at which, banks can lend to each other. These shifts can affect short-term rates for business and personal loans. But still, there are many limitations for the Central Bank to control these rates (for example: possibility of a deflationary environment).

Myth #2: Higher interest rates are always good for the common working class for savings: This myth is well busted by Dr. Raguram Rajan. He addressed the issue beautifully in a single statement,

“Lower interest rates at lower inflation is better than higher interest rates at higher inflation”.

Often people tend to miss two things:  The inflation that has to be accounted in the nominal interest rate.  Higher interest rates affect common people directly or indirectly. Apart from the higher Future Value(FV) of their savings accounts, higher interest rates increase the cost of borrowing increasing opportunity costs for different business and developmental projects taking place in the economy.

Myth #3: Higher interest rates are always bad for equity markets: Once again, this can hold true in many cases. But still, this can depend on the circumstances. The bond and share markets can often go together on a bull run for short term spans. Bond markets are greatly dependent on inflation rate variations. While, share markets can tolerate an increase in interest rates for short spans.

Myth #4: Interest rates are always positive: Swiss Policy rates in early 1970s, Swedish policy rates in 2009–2010 and European Central Bank in 2014 are examples for instituting negative interest rates in an economy. This is largely a last move for boosting economic growth in the short term.

Interest rates are set by Central Banks towards the best functioning of the economy. There is a load of variables that are being monitored for this purpose. An economy’s growth is directly related to the policy rate of the Central Bank and its Neutral Interest Rate(NIR). If the policy rate is higher than the NIR, it means that the policy is tight and increased cost of borrowing slacks private investments and ventures. While a policy rate lower than the NIR drives the industrial growth, boosting the economy. Now in India, RBI has increased the policy rate by 0.25 bps declaring a ‘calibrated tightening’ policy. This is to ease the liquidity concerns. Following table compares the effects of an increase in interest rates that concerns the common people as well as the economy as a whole:

We see a balance don’t we?