What’s in an interest rate? – Part I

Unless you’ve been in solitary confinement, living with wolves, or in hiding from the impending zombie apocalypse, you would have noticed recent headlines on interest rate decisions by the world’s monetary authorities.

During the month of September, the Central Banks of the European Union, the United States and South Africa, all decided to either lower, raise, or leave unchanged the rates of interest in their respective territories.

Not only did the expectations of these decisions have a material impact on the value of financial market assets – ultimately your and my investments as well – but the after-effects similarly directed the actions of millions of market participants the world over.

In short, interest rates matter… they have tangible effects on our day-to-day lives, and you should be paying attention!

What is an interest rate?

Colloquially, we think of an interest rate as the percentage we get paid on keeping our cash savings in a bank account, or the percentage rate we are charged yearly for the loaned funds we’ve used to purchase our cars or houses.

While these are all examples of specific interest rates within an economy, we can more generally define an interest rate as:

‘The amount a lender charges for the use of assets expressed as a percentage of the amount lent, deposited or borrowed (called the principal sum).’

The assets borrowed could include cash, consumer goods, or large assets such as buildings or vehicles themselves. For purposes of this article, however, we will focus on the case of cash, or money.

Why is there an interest rate?

Interest is an economic phenomenon which traces back to the fact that humans, when given the choice, prefer things now rather than later. This is known as Time Preference, and according to the writings of Austrian School economists Carl Menger and Ludwig von Mises, is the driving force of interest rate determination.

Time Preference has been allegorized in several familiar proverbs like, ‘a bird in the hand is worth two in the bush.’

Ultimately, our preference for things now rather than later is a consequence of the fact that life is uncertain. No one can know what the future will bring, so most actions a person takes reflect a preference for immediate, over postponed or delayed, satisfactions.

‘Satisfaction of a want in the near future is, other things being equal, preferred to that in the far distant future. Present goods are, therefore, more valuable than future goods.’ von Mises

Accordingly, those who postpone immediate consumption or the usage of their monies now, and elect to rather loan it out to someone else for the others’ consumptive purposes, are rewarded with interest – the additional amount of money returned to the lender at some stipulated future date, over and above the loaned amount.

Real Wealth and Time Preferences

An individual who has just enough resources to keep himself alive is unlikely to lend or invest his paltry means. The cost of lending to him is likely to be very high — it might even cost him his life if he were to consider lending part of his means. So under this condition, he is unlikely to lend or invest even if offered a very high interest rate.

Once his wealth starts to expand, the cost of lending starts to diminish. Allocating some of his wealth toward lending or investment is going to undermine, to a lesser extent, our individual’s life and well-being at present.

From this, we can infer that anything that leads to an expansion in the real wealth of individuals gives rise to a decline in the interest rate (i.e., the lowering of the Time Preference for money). Conversely, factors that undermine real wealth expansion lead to a higher rate of interest (i.e increasing the Time Preference for money).

Interest Rates are Prices

In the economy as a whole, individuals’ time preferences are realized through the supply and the demand for money.

At any one time, there is a given amount of total money stock circulating in the economy. The proportion of this stock available as loanable funds then is the supply. Conversely, the demand is then the demand for credit in the economy.

The supply proportion must be matched to those demanding credit in the marketplace by way of prices.

Like any good, service, or asset that humans demand, there is a price for its attainment and usage. Why? Because we’re competing with other humans for that good.

Effectively then, the interest on a loan is simply the price of that money. Those borrowers who can afford the interest rate will thus be matched up to those lenders willing to accept the interest rate.

When Central Banks Intervene

So when news networks announce the central banking authority has ‘cuts rates’ or ‘hiked rates’, it means that central authorities have decreed the price of money to be a certain interest rate. The authority’s central banking committee, thus, replaces the market mechanism in determining the price of money.

When the interest rate is set by the market, however, it reflects the aggregate time preferences of individuals and the real stock of wealth (read: savings) in society. When the interest rate is set by a Central Bank, like The Fed, ECB, or South African Reserve Bank, it creates a dangerous distortion in market signals to society.

To find out what these interest rate changes today could mean for you and how to navigate such change, read part II of this article series next week.

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