The Foundations of Finance – Interest Rates

The Independent says that “interest rates will directly affect the victims of austerity”. The Telegraph says that “it may take time for the [interest] rate rise to be reflected in the savings accounts on offer and savers will need to be patient”. But perhaps the most damning statement is from The Herald: “The interest rate rise marks an important milestone in the UK’s recovery from the financial crisis”.

But what does this all mean? In order to find out, it’s important we first look at who controls interest rates before defining the concept and understanding its various effects.

Interest rates are equivalent to “the cost of borrowing”, “the cost of debt”, or the “reward for saving”

Interest rates, once controlled by the government in Westminster, are now set by the 9 members of the Monetary Policy Committee (MPC) in the Bank of England. Their main priority is to maintain price stability within the UK’s inflation target of 2 per cent – that is, the general increase in prices, alongside supporting “the government’s economic objectives including those for growth and employment”.

As the Bank of England puts it: “interest is what you pay to ‘hire’ someone else’s money”. Interest rates are equivalent to “the cost of borrowing”, “the cost of debt”, or the “reward for saving”. It is the “rental” or “leasing charge” to a borrower for the use of an asset, which is something of value, such as a car, house, or even money.

Yet, any form of borrowing – financial or non-financial – involves a degree of trust. I wouldn’t lend you my Ferrari 458 if I had evidence to prove you were more likely to crash cars than you were to brush your teeth every morning.

Why banks would use interest rates… include: maintaining a consistency of net profits earned in recent years; attracting more customers than its competitors

Therefore, if the borrower is a “low-risk party” or someone trustworthy, which would include well-known high-earning large corporations such as Apple Inc., banks would offer a lower interest rate to these companies as opposed to the recently opened Donny’s Peri Peri chicken on your local high street.

There are various reasons why banks would use interest rates, some of which include: maintaining a consistency of net profits earned in recent years; attracting more customers than its competitors; and responding to the possible future market or industry the company may find itself in.

If we come back and apply this to Apple, the company: has earned more than $45 billion since 2015; has the largest market share by almost 5 per cent as of 2017; and is in an exponentially growing technology market which has tripled in size since 2012, according to NASDAQ 100.

Contrarily, the newly opened Peri Peri would find itself in a highly concentrated fast-food market, where there may be more than one fast food alternative on the high-street or on any other road within a walkable radius that Donny would need to compete with.

Thus, a bank would have more confidence in lending money to Apple, because they have proven to be more reliable in providing income with projections to earn more, as opposed to Donny’s Peri Peri, which hasn’t even sold a portion of chicken and rice with chips yet.

Returning to the MPC’s commitment to upholding the government’s manifesto commitments, interest rates are also used to serve macroeconomic agendas of government’s in power.

Consumers and businesses [are] incentivised to borrow money to spend, as the burden of interest is lower, but savers did not enjoy the same benefits

Following the Brexit referendum in 2016, interest rates were cut – for the first time in 7 years – to 0.25 per cent from 0.5 per cent, a level not seen in the BoE’s 324-year history. The aim was to boost consumption while Britain’s “economic fallout” becomes clearer.

Consumers and businesses were incentivised to borrow money to spend, as the burden of interest is lower, but savers did not enjoy the same benefits. As saving is made redundant by lower interest rates – as there would be slower growth in one’s saving account – savers are also encouraged to take money out of their account and join in with consumers.

However, whilst Brexit catalysed domestic spending, it did not fare well with foreign direct investment, showing signs of waning confidence.

Nevertheless, Steve Varley, UK Chairman at Ernst and Young, commented: “Whilst investor sentiment towards the UK has dipped in the immediate aftermath of the EU Referendum, our analysis shows that many businesses are willing to wait before making any significant investment decisions.

“What that means is that there is time for the UK to craft policy responses, to mitigate any long-term adverse effects on foreign direct investment into the UK.

“However, time is of the essence. The preliminary agreement on transition, announced last week, may well spark action from businesses.”

Whether it is the relationship between businesses and its clients, or the government and its electorate, interest rates are there to stabilise, and in some cases boost economic growth towards a more prosperous future. Interest rates are here to stay – so you might as well know of it, and its consequences.