We all know it happens, but have you ever actually asked yourself: why do interest rates go up and down? If you have, then you might already know that the simple answer, is inflation.
If you haven’t (or just want to know more), then it’s definitely a topic worth exploring in further detail — starting with the role of credit.
Without credit, the economy would be a simple system where you provide something of value to society, get paid, and spend the money to meet your needs and desires.
In other words: your income is someone else's spending, and your spending is someone else's income.
Even though this would be a simple economy, it would also be a highly inefficient one.
And that’s why credit is a game changer — because it allows people to bring future income forward.
Why is credit needed?
Imagine, for example, having to buy a house in cash, or a government having to save for 50 years to build roads and hospitals; both situations would not only be inconvenient, but disastrous for the economy, too.
The financial system exists to avoid this issue, making it possible to transfer money to those who need it today, from those who don't, at a reasonable price (or interest rate).
Credit accelerates consumption and economic growth, as it allows people to spend money they don't have. And, because your income is someone else's spending, when that spending is turbocharged with credit, your income also gets a boost.
In turn, this higher income fills you with confidence about the economy, which encourages more spending — and even more borrowing. This domino effect continues, increasing the amount of credit until we have to pay it back.
However, it’s really important to remember that credit may not be suitable for everyone, as it comes at a cost and could negatively impact your credit rating.
Please seek financial advice if you’re unsure. Periods when we spend more than we earn, are followed by periods when we spend less; the same force that propelled the economy upward, now works against it. This is what we call a credit cycle.
Interest rates and the credit cycle
Central banks use interest rates to manage the credit cycle. Think of interest rates as the price of money, which can influence our willingness to lend and borrow.
Low interest rates encourage spending, providing companies with access to cheap capital that can be invested in projects.
Overall, low interest rates increase economic activity and, in some cases, create inflation.
High inflation rates, however, are a problem for several reasons.
Our hard-earned cash loses value, which then increases our cost of living.
We ask our bosses (or the government) to increase our wages, only for prices to be increased to protect the company's profits — which creates more inflation!
And when inflation gets out of control, things can get bad very quickly, which is why interest rates are increased to cool down the economy and reduce inflation.
Low inflation rates – or deflation – are also a problem.
Let’s say we’re seeing the value of houses going down over time; people might delay purchases in the hope of buying things at a lower price, which reduces demand. As with all investing, however, the value of your investments can go down as well as up, meaning you could get back less than invested.
The central bank's job is to find the interest rate that keeps inflation at the sweet spot of 2% on average.
People deposit and borrow money from commercial banks, which act as financial intermediaries; your bank deposit will be someone else's loan, and vice versa. In a similar way, commercial banks deposit and borrow money from the central bank.
Commercial banks only keep a small percentage of customer deposits as reserves, with the rest used to provide loans to other customers. This is how banks make money.
Interbank lending
Because banks aim to optimise their reserves, they’ll often borrow money overnight from the central bank – or other banks – to manage their liquidity (how quickly they can get their hands on cash).
This is known as interbank lending — and you can think of it as an overdraft facility for banks.
The amount of money customers deposit on any given day is unlikely to be the same as the amount withdrawn; a situation that makes overnight lending between banks a daily occurrence.
The base rate set by the central bank – the one you see on the news – is the rate at which commercial banks can borrow from the central bank.
In turn, the base rate influences the interbank rate which, in the UK, is called SONIA (Sterling Overnight Index Average).
At the same time, the interbank rate impacts the interest rate at which you can borrow money from the bank, as well as the savings rate on offer.
Although the base rate influences the direction of other market rates (such as SONIA, savings, and mortgage rates), they don't move in perfect unison.
A balancing act
What’s more, if interest rates and inflation were friends on Facebook, their relationship status would be: "It's complicated". Even though interest rates do influence inflation over the long term, there can be some major delays.
And, when all is said and done, that's the ultimate challenge facing central banks: being able to find the right level of interest rates today, to influence inflation and economic growth in the future.
Wealthify does not provide financial advice. Please seek financial advice if you are unsure about investing.
Please remember the value of your investments can go down as well as up, and you could get back less than invested. Past performance is not a reliable indicator of future results.
Your tax treatment will depend on your individual circumstances, and it may be subject to change in the future.
