Zaks Investment Advisory Service

Interest Rates: a review

While we were discussing stocks and bonds, we came to mention interest rates on several occasions, and how their rates affect both the prices of stocks and bonds. What are interest rates?

By definition, interest rates are loan charges, or the price of a loan. Suppose that a company borrowed money from a bank (took out a credit). On a set date, it must return this money and pay an “interest.” Why, you may ask? No one ever paid interest to banks in the Soviet Union, so surely an economy can function without interest rates. Yes, a planned economy might, but not a market one.

Interest rates exist because in a free, market economy, there are always groups (whether of people, companies or other organizations) that need money right away, whether it is to build something (like a new factory or house), to create (a new company, for example), or to buy (say, a car). On the other hand, there are other groups that have money they would be happy to invest in order to earn an “interest.” Creditors give out money on loan, hoping to earn an interest that outpaces the level of inflation. In addition to inflation, the interest must also compensate for the risk that the money might not be returned. This is a way for creditors to earn money, and for many of them – their main line of business: this, for example, is what the banking business is all about. Borrowers, who take out money on loan, hope that they can use this money to earn better returns than the interest they will pay back the creditors (this is the hope of a company that borrows money in order to expand a plant). Or, like many consumers, they would like to afford something for which they currently lack the cash (a house, car, education at a good university), but which they hope to repay later.

Borrowing money is not necessarily done through the bank. When a company issues bonds, it borrows money from individual investors or financial companies that purchase these bonds. Our government does the exact same thing: it is constantly short of money, and it issues bonds. When you buy a federal government bond, you turn into a creditor, and the government – into a borrower.

From the creditor’s perspective, interest is a wonderful thing: the higher it is, the better the return. For example, if you purchase bonds, it would be more lucrative to have higher coupon payments. But for the government and companies that issue bonds (as, in fact, for any other borrower), interest payments are an expense. Borrowers would like to see interest rates as low as possible. By the way, if you, for example, keep money in your bank’s checking account, which pays no interest, you are paying what economists call an “opportunity cost,” or the cost of lost opportunity. If you keep small amounts in your checking account, then this opportunity cost is not large, but of you keep a lot – then, of course, it rises.

So what determines interest rates? As we have already learned, interest rates are the price of credit, and like everything in a market economy, it is determined by supply and demand. Supply grows when the amount of money that could be potentially borrowed grows. This happens in many different ways. For example, when you deposit money in your bank, your bank obtains additional resources through which it may issue loans to businesses or individual customers. This creates greater supply. In exactly the same manner, you create supply by investing money in the bonds of a certain company. If a foreign central bank decides to buy several billion dollars worth of federal government bonds, this also increases the supply of credit. Demand for credit, meanwhile, grows when a firm asks the bank for a loan, or when you decide to borrow money for the purchase of a home, or else when the federal government borrows money by issuing bonds. All of these operations affect the credit market and, consequently, the interest rates. Supply and demand are the market mechanisms that regulate interest rate levels. Usually, when the economy is growing quickly, demand for credit grows and interest rates go up. When the economy falls into recession, interest rates drop.

We mentioned that a creditor would like to earn an interest that exceeds the inflation rate. Interest rates depend on the level of inflation and the purchasing power of money a great deal. For example, if you borrow $1,000 over three years, then in three years’ time, those $1,000 will not have the same purchasing power as they do today. It falls because of inflation. Thus, simply in order to compensate for the fall in purchasing power, creditors must receive a certain “interest.” In order to make real returns, the creditor must add a certain “interest mark-up.” This “interest mark-up” is called the “real interest rate.” The total interest rates quoted in newspapers and which we use to calculate how much we owe the bank are called “nominal interest rates.” But we have just learned that these are made up of two components: the inflationary mark-up, which compensates for the assumed inflation rate, and the real interest rate.

With this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.