Entries Tagged 'interest-rates' ↓

Readers Question: What is the negative and positive impact of rising in the interest rate on financial market?

Higher Interest Rates and Stock Markets

Higher interest rates are often seen as bad news for the stock market.

Higher interest rates tend to slow down economic growth. Borrowing is more expensive therefore, firms will invest less and consumers will spend less. Because higher rates lead to lower growth, companies will make lower profits and therefore pay less dividends.

Futhermore, higher interest rates make it relatively more attractive to save in banks rather than invest in the stock market.

Of course, there are many variables affecting stock markets other than interest rates, but, ceteris paribus higher rates tend to be seen as bad in the short term.

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Readers Question Expansionary stance of monetary policy will lead to a lower interest rate thus discouraging hot money (portfolio I) leading to less outflow of Y and improve CAD. (based on lecturer’s notes)

Doesn’t the discouraging of portfolio I lead to spending more than S and Outflow>inflow thus leading to worsening of CAD??? I’m awfully confuse now. Please clarify and thank you.

If interest rates are cut, there will be less hot money flows into the UK. The UK will be less attractive as a place for investors to save. Therefore, there is less demand for sterling on the foreign exchange markets. This causes a depreciation in the exchange rate.

However, just because there is less demand for sterling on the foreign exchanges doesn’t mean lower Consumer spending. (I assume CAD = consumers Aggregate Demand)

A lower exchange rate will actually boost Aggregate demand in the UK. Firstly exports are more competitive therefore higher demand for exports. But, also imports will be more expensive therefore, people will be discouraged to buy imports and therefore buy more domestic goods.

Lower interest rates will increase consumers spending in the UK because:

• Less attractive to save
• Mortgage payments are lower therefore more disposable income
• Loans are cheaper encouraging borrowing.

THerefore lower interest rates definitely (ceteris paribus) increase consumer spending

For manufacturing investment, the real Interest Rate is important for determining the viability of investment. Generally, industry prefers real interest rates to be low, to encourage investment. High real interest rates discourage investment.

The Real Interest Rate is the Nominal Base rate - Inflation. If The Official Interest Rate is 7% and inflation is 5%. It means savings would increase in value by 2%. The real Interest rate is important for many reasons.

• Reflects the cost of borrowing. A higher real interest rate increases the cost of borrowing and makes investment less profitable. (This is not an issue if the finance is raised in UK) However, if it is necessary to borrow in the particular country the real interest rate is very important for determining the profitability of investment.
• Determines Economic activity. Interest rates influence the level of economic activity in the economy. Higher rates discourage borrowing and encourage saving. Therefore, in countries with high interest rates, consumption and investment tend to be lower. This could reduce domestic demand for your manufactured goods.
• Influences the exchange Rate. A high interest rate causes an appreciation in the exchange rate, making exports less competitive. If the manufactured goods are to be exported a high exchange rate can be quite a problem.
• (However, a strong exchange rate will make imports cheaper)

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Readers Question: The Bank of England has released £15bn into the economy. That increase in the money supply will surely cause inflation? So interest rates having fallen will be raised, worsening the housing market and making the credit crunch even worse, not better….surely?

The Bank of England is planning to inject money, primarily into the mortgage markets. It will be unveiling a plan today to release money into the money markets to help banks finance mortgages.

This particular increase in the money supply is unlikely to cause inflationary pressure.

• Even if the Bank of England increased the Money Supply by £50billion, it is still a small % of total GDP. (over £1,200bn).
• Total UK Mortgage debt stands at £1.19 trillion — or about 84% and there mortgage companies are struggling to raise sufficient funds because credit has dried up on the money markets. Many analysts suggest that this £50billion is unlikely to sovle the problem of credit shortages. (BoE plan to inject money)
• The injection of £50billion will have a positive effect on the Money supply, but, it comes at a time of declining credit and availability of money. Demand pull inflation is not a problem at the moment.
• If the Bank had injected £50 billion at the height of the lending boom in 2006, then the injection of money at that time may have caused inflationary pressure, but at the moment, they are merely trying to restore a semblance of normality to the mortgage sector - it will not  cause a lending boom.
• The most serious threat to inflation at the moment is coming from cost push factors. But, it maybe that the Bank feel they need to allow inflation to go above the target rather than risk a recession.

Readers Question: Hi, Please could you explain this question…

Contrast the likely effects of monetary policy decisions on the price of housing and shares.

Monetary Policy involves changing interest rates to try and influence aggregate demand and target low inflation and high growth.

If inflation was increasing above the governments inflation target, they would increase interest rates to reduce inflationary pressures.

Effect on Housing

Higher interest rates increase the cost of mortgage interest rate payments. Therefore, it makes it less attractive for people to buy a house. If interest rates increase too much, some people may not be able to afford their mortgage payments and default on their mortgage. This means they will have to sell their house. This effect will be to reduce demand for houses and therefore lead to lower house prices.

Note: In the US, many people took out risky mortgages in the period 2001-06. These mortgage payments were a high % of their disposable incomes. Therefore, a small increase in interest rates from 2% to 4% had a serious adverse effect on the US housing market. In France or Germany, these kind of mortgages are less common and therefore, higher interest rates would have much less impact on house prices.

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Readers Question: Could u pls explain to me how the volume of private investment depends on the rate of the interest and marginal efficiency of capital?

Private investment is an increase in the capital stock such as buying a factory or machine. (investment in this context does not relate to saving money in a bank.)

When firms and individuals decide how much investment to make interest rates and marginal efficiency of capital are important.

Interest rates. If interest rates are high then it makes it expensive to borrow money. This will deter investment because investment is often financed through borrowing. Also when interest rates are high it makes it more attractive to save money. Investment is often financed out of retained profit. High interest rates mean that investment is relatively less attractive than saving money in a bank.

• Assuming inflation is zero, and interest rates are 3%. Then any investment project would need an expected rate of return of at least greater than 3%. If interest rates were 6%, then any investment project would need an expected rate of return of at least greater than 6%, and therefore less investment would occur. Continue reading →

Yesterday, the Bank of England released its inflation forecasts for 2008 and 2009. It suggests that if base rates are kept at 5.25% then inflation will stay close to 2%. However, if they cut interest rates to 4.5% (as many in the City have been predicting) then inflation is likely to breach the 3% target.

The Bank, therefore, have a difficult balancing act. On the one hand we have rising inflation (from cost push factors, especially food and energy) but we also have a slowing economy.

Although, the Bank are keen to point out the weaknesses of the economy, they seek to avoid the gloom that has surrounded some sectors of the economy. The Bank suggest this year may merely invovle a rebalancing. Sectors that have done well previously will be slowing down. These sectors include:

1. Housing Market
2. Financial sector in city of London
3. Mortgage lending
4. Consumer Spending

However, other sectors which have struggled in the past, could do better in the coming years. These sectors include:

Manufacturing, export sector.

The inflation forecast also came out on another good day of employment figures, with falls in unemployment.

For more details see:

• Mortgage interest rate forecasts
• Bank of England Inflation forecast 

Readers Question: Interest rates are determined by the markets and not by the Bank of England-where’s the truth?

An interesting question.

Firstly, it is worth bearing in mind that there are different interest rates in an economy.

Bank of England Base Rate. This is the most important interest rate because it is the rate at which other commercial banks need to borrow from the Bank of England. Therefore, the base rate is an important determinant of other rates in the economy.

Generally, speaking the Bank of England is free to set base rates to achieve its target of low inflation CPI 2%+/-1. At certain times markets may pressurise the Bank of England to change rates, but largely the Bank of England is free to set rates depending on how it sees fit.

• ERM crisis. in 1992, the government increased interest rates to 15% to try and protect the value of the £ (which was then in the ERM) However,  the markets felt this interest rate was unsustainable in a recession. Therefore, people continued to sell pounds effectively forcing the £ out of the ERM and making the UK cut rates. This is an example of market forces forcing the monetary authorities to change interest rates, but, it is relatively rare.

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Earlier today, I wrote about the effect of the stock market on the economy. One thing I forgot to mention is the effect of the stock market on Central Bankers.

The Federal Reserve were supposed to meet on January 29th, where markets expected a 0.5% cut. However, the Fed decided to have an unscheduled meeting and cut interest rates by 0.75%.

Graph of US Interest Rates

It appears the main motivation behind this ‘panic’ measure is to prop up falling stock markets.

However, with market sentiments pessimistic, this cut to boost confidence may misfire. Firstly, was it really necessary to bring the rate cut forward by one week? Why were interest rates cut by 0.75%? A suspicious Wall Street may ask do the Fed know something we don’t know? (Wall Street fell by 400 points after the announcement)

I wrote some of the economic effects of this recent rate cut on the US economy here

Although the Housing market is creating serious economic problems, the Fed have a reputation for over reacting to stock market concerns. It will be interesting to see whether they can get it right this time.

Problems of Cutting Interest Rates 

Desperate Measures at Economist 

Readers Question: What is  Amortisation ?

Amoririsation is the running down of a loan through regular payments. A good example is a capital repayment mortgage. In this case the homeowner pays monthly installments paying both interest on the loan and also capital repayments. This means that after 30 years the loan will be paid off.

The opposite of amortisation is an interest only mortgage. With an interest only mortgage, only interest payments are made. This means that the capital debt of the loan remains. Usually, with an interest only mortgage the borrower is required to find an alternative investment plan to be able to pay off the debt.

See also:

• Interest Rates explained