Oran Hall | The good and bad of changing interest rates
Interest rate movements can be beneficial and harmful to the public at the same time, depending on whether money is being borrowed, saved or invested.
Higher interest rates are good for savers, investors in new fixed-rate bonds and investors in variable-rate bonds, but bad for investors selling fixed-rate bonds before their maturity date. They may also affect prices on the stock market adversely, and make it more costly to borrow.
Lower interest rates, on the other hand, generally have the opposite effects on savings, investments and borrowing.
The Bank of Jamaica, BOJ, has taken steps to temper inflation by increasing its policy interest rate – its benchmark interest rate.
“The policy interest rate is the interest rate that the central bank pays on balances in the current accounts of deposit-taking institutions held at Bank of Jamaica. Changes in the central bank’s policy rate signal the BOJ’s policy stance towards achieving its inflation objective.
When the central bank wants to tighten monetary policy, it will increase the interest rate and will lower the policy rate when it wants to loosen monetary policy. These changes are then transmitted to prices through the financial markets and then through spending and investment decisions.
The policy rate represents the floor of the central bank’s interest rate corridor. This corridor defines a band within which short-term money market rates are expected to move. The floor of the corridor is the bank’s policy rate while the ceiling is the interest rate on the BOJ’s standing liquidity facility, the SLF.
The SLF is an overnight facility through which the BOJ assists the banking institutions it regulates with short-term liquidity.
When interest rates increase, individuals and institutions that have surplus funds benefit by earning more on savings instruments, but earn less when interest rates decline.
Investors who place funds in interest-bearing instruments, such as bonds and debentures, in the primary and secondary markets benefit when interest rates are relatively high but are disadvantaged when they buy such instruments issued when interest rates are relatively low.
Investors already holding variable rate instruments also benefit as the return to them is computed on the rate on a specified instrument plus a specified amount of percentage points.
The holders of variable rate instruments benefit because the instrument used to determine the rate is generally a treasury bill, the rate of which is determined by tender.
Although the returns on variable-rate instruments fall when interest rates fall, they do not do so as sharply as the rates on fixed-rate instruments.
Interest rate movements also affect the capital values of fixed-income securities because of the inverse relationship between interest rate changes and bond prices, that is, when one increases the other declines.
The investor who holds these instruments to maturity is not at a disadvantage, but those who sell before the instruments mature will likely experience a capital loss when interest rates increase due to the decline in the price.
On the other hand, the value of such instruments increases when interest rates decline, thus yielding a capital gain to the investor who sells before the redemption date.
The effect on short-term instruments is less pronounced on short-term instruments and on high coupon instruments.
Institutional investors, especially those operating unitised funds, unit trusts and pension funds, for example, will likely see a decline in fund and unit values when higher interest rates cause the price of bonds to decline if their policy is to adjust the value of the securities in the portfolio even if they do not sell them. This is known as marking to market. The opposite happens when interest rates fall.
In terms of income, higher interest rates generate higher levels of income to the investor.
To the extent that investors see higher interest rates as attractive, they may opt to invest in interest-bearing securities rather than in the stock market, which may cause lower demand for stocks and thus lower prices.
Listed companies which stand to benefit from higher interest rates may generally become more attractive to investors, but those likely to be hurt may become less attractive to them.
Borrowers are also affected when interest rates change. If the interest rate is fixed for the term of the loan, it matters little. If the rate is adjustable, meaning it changes over time based on the lender’s cost of funds, or if it is variable, meaning it is based on the movement of market rates as reflected in the rates of BOJ’s short-term instruments, increasing rates do not make good music to borrowers.
This grand mix of rates tends to be more common in the mortgage market than elsewhere in the financial system.
Borrowers should be clear about the basis on which interest is determined on any loan before making a commitment to borrow.
Higher interest rates are expected to lead to lower demand for goods and services and thus lower inflation. Depending on the extent to which the demand for imports decline, depreciation of the value of the local currency could also be moderated.
Understanding how interest rate movements affect the economy and the financial markets can go a far way in making effective financial decisions.
Oran A. Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. finviser.jm@gmail.com