Interest Rates

All of us are confronted to interest rates every day of our lives, because we all own a little bit of money or maybe some student debt or even a lease contract on a car. Therefore, you may wonder, why do interest rates exist? Who sets them? How are they computed? Why do they change? What drives them upward or downward?

Let’s start at the beginning: why do interest rates exist? Well, imagine you’re lending one franc to a friend. During the lending period, you cannot use that franc, therefore you’re undergoing some sort of cost. Economists call this the cost of opportunity. This is quite intuitive since it’s the cost of not being able to seize an opportunity during that lending period, for example buying a delicious ice cream. Now, imagine your friend wants to use that franc to engage in some risky business, that may or may not succeed. Consequently, your money is now bearing that risk of success/non-success. You want to be compensated for that risk, and that is why you will ask him to give you back more than one franc. The additional money is the interest rate.

The cost of opportunity of money and the risk are the two components of the time value of money. This is one of the most important concepts of our economic, financial, and monetary system, and if you have understood the previous paragraph, then you will understand this: one franc today is worth more than one franc tomorrow. Of course, since owning one franc today allows you to lend it and earn more than one franc tomorrow thanks to interest rates, which are just the financial translation of the cost of opportunity and the risks.

Another crucial concept regarding this subject is the concept of inflation. You have probably heard about it before, but let’s fully clarify what it is here. According to our dear Wikipedia, inflation is a sustained increase in the general price level of goods and services in an economy over a period. So, if the price of goods rises over a period (inflation), you cannot buy the same amount of ice creams at the end of the period than at the beginning. Therefore, your money is worth less. Remember, money is only worth what you can buy with it.

Let’s link this concept of inflation with the concept of interest rates. Imagine you are lending one franc to your friend for one year. You agree together on an interest rate, compensating fairly for the cost of opportunity and the risk; let say 5%. Over that year, the level of price rises. Inflation has occurred. An ice cream is now worth 1.02 francs. Inflation was thus 2%. Your friend reimburses you 1.05 francs, but the ice cream you want to buy is now worth 1.02 francs. The real interest rates you have earned, in terms of ice creams, is the difference between inflation and the money amount (nominal interest rate) you have earned. In this case it amounts to 3% ((1.05-1.02)/1). The equation linking these three concepts is called the Fischer equation. The nominal interest rate equals the I-inflation plus the real interest rate.

The causes of inflation are a disputed question, and a great deal of literature was concerned with the question. Intuitively, you can grasp that larger amounts of money in the economy will lead to inflation, since everybody owns more money and consequently are willing to pay more for the same goods. You can also understand that if some important goods to the economy (such as oil) are highly demanded, their prices will rise (along with all oil derivatives and oil dependent products). That is why our monetary and financial systems are also oil dependent.

Who sets interest rates? Before tackling this question, understand the following: owning cash is not free, there is a certain value attributed to the simple fact of holding money. Can you guess why? Of course, you can. From the previous paragraphs, you now understand that if you are holding money, you are not lending it, and therefore, you are not earning that interest rate we talked about. The interest rate is also the cost of holding money in cash. The agent responsible for managing the amounts of money in an economy is the central bank. Thus, it is the central bank that controls its interest rate. In the US, this rate is called the federal funds rate. This is the rate at which commercial banks will lend to each other (approximately). Now, you must understand that there are thousands of different interest rates on the market, but that all these rates are somehow related to the federal funds rate. For example, when you are taking on debt to buy a car, you will typically be charged a higher rate than the federal funds rate. There are several reasons behind this: first, there is at least one financial intermediary between you and the federal funds rate, usually a commercial bank. Second, as an individual, you are bearing much more specific risk than an institution like a Credit Suisse, or any other commercial bank.

Now that you know who sets the guiding interest rate, you can guess why interest goes upward or downward. Each central bank has its particular mission, but all central banks have in common that they usually have an inflation target, and a certain mission concerning the country’s economy. The mission of the Swiss Central Bank is stated in the following mandate: The Swiss National Bank (SNB) conducts the country’s monetary policy as an independent central bank. It is obliged by Constitution and statute to act in accordance with the interests of the country as a whole. Its primary goal is to ensure price stability, while taking due account of economic developments. In so doing, it creates an appropriate environment for economic growth.

If interest rates are low, this will generally initiate economic growth, since any entrepreneur can borrow money without having to pay much interest. On the other hand, high interest rates are a barrier to entrepreneurship, since it is then very expensive to borrow. Therefore, you may state that low interest rate is an accelerator, while high interest rates is a brake, inflation is a speed limit, and the world markets (import-export) is the road. Managing the SNB is pretty much like driving a big truck.

For the sake of intuition and understanding, I simplified many of the concepts. If you want to dig deeper into interest rates, come attend some of HEC’s classes!

Charles Emsens