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  • Writer's pictureMathieu Provencher

Why are interest rates increasing around the world?

(Picture from Wix's library)

Hello everyone! I know I have not been around for a long time now but I will be trying to write again to keep you informed and, hopefully, entertained with Economic knowledge.

This month I want to take some time to discuss interest rates in an economy and their link to Economic output and, perhaps more importantly these days, inflation.

Let’s start with a few statements I came across on different outlets, things you may have heard yourself or thought they were right (spoilers: they are wrong): (1) Banks are increasing their interest rates to increase their profits after the pandemic lock-downs; (2) Banks agreed to work together and squeeze more out of their clients; (3) The government is helping banks by increasing interest rates for nefarious reasons (bribes, lobbying, etc.).

Now, to properly explain how interest rates work and how they interact with the entire banking system of the great majority of countries… I would need at least three hours of class time and your full attention. Although I am sure most of you would be very happy reading pages after pages of details on how all of that work, I will not indulge you guys on that today. Let me instead give you the big picture of how interest rates are decided and what impact they can have on the Economy. After this, you should see very clearly how the three previous statements (and many other similar ideas) are wrong.

First of all: what are we talking about? Interest rates are a ‘price on time’ that financial institutions (banks for example) use to compensate for money borrowed today. This works for both the money you ‘lend’ them (through deposits for example) and money they lend to you (when you use your credit card, if you don’t pay back on time, or take a mortgage). The interest rates they give you (for your deposits, particularly savings accounts) and the ones they make you pay (when you take a mortgage) are not the same rate for many reasons, including the risk of default.

Second of all: who decides on what level of interest rates banks can ask? Well… this is where it gets a bit more complicated. Ultimately, banks can decide on their own in most countries, including most advanced economies (Canada and the USA being in that category). However, the Central Bank of a country, which is a special branch of the government, gives some sort of guideline to what interest rates should be around. That guideline is called the ‘overnight rate’ (taux directeur) in Canada and the ‘federal funds rate’ in the USA. This is not exactly a suggestion and has a lot more influence than a simple guidance but going into the details is where I would need a few hours with you guys. Suffice to say that the Central Bank of the country and what we call ‘commercial banks’ act together to decide what the interest rates will be in the economy.

Third of all: how are interest rates related to economic outcomes, such as production and inflation? Again, let’s see a simplified version of the facts, which should give you a good idea of how monetary policies work through changes in the interest rates. When borrowing money, perhaps to buy a house, a car, a new machine, or a factory, economic agents, that’s you, me, and firms in this case, will (hopefully) pay back the loan plus interests. As such, higher interest rates means that buying expensive stuff will be even more expensive. SO, raising interest rates will likely discourage some purchases that require a loan, and less purchases in the economy will likely slow down the economy. When inflation is spurred by speculation and buying of expensive hard assets, such as houses, an increase in interest rates should slow down purchases, which in turn should slow down inflation. Not only will higher interest rates lead to higher prices for expensive things (if a loan is taken), but it also makes it more interesting to save your money… because you receive more from your savings account. These two forces, making expensive things more expensive and making you save more, lead to less economic activity and help reduce inflation.

Now… to the meat of this article: why are we seeing interest rates increase around the world? As you may know, we have a lot of inflation around the world right now. That inflation comes from a number of factors, which I hope you have seen in different outlets. I told my students in Q4 of 2021 that inflation was most likely going to stay strong, and even increase, for another 6 months to a year at least. I said that while Central Banks around the world, and the IMF, were telling us that inflation was ‘transitory’, temporary if you wish… what a joke that ended up being.

Anyways! Central Banks are now trying to reduce the amount of inflation in their respective economies. They are now doing what I said they should have been doing starting around 2014 or so: increasing interest rates and decreasing what is called quantitative easing. I will not go in any details on the second policy but know that they both work together. As such, increasing interest rates in the economy, with commercial banks following that ‘guidance’ from the Central Bank, should slow down the economy a bit, particularly for very expensive stuff, and should lower inflation.

That, in a nutshell, as they say, is why we see interest rates increase around the world: to reduce the level of inflation. This is not some conspiracy between banks or between banks and the government, this is the type of policy Central Banks have been following for more than 30 years (in Canada and the USA at the very least) when faced with high levels of inflation.

Commercial banks that increase their interest rates for the mortgages they give also tend to increase the interest rate they give to savings accounts. Also, higher interest rates on borrowing means less people are going to borrow. These two factors together mean that commercial banks don’t tend to make much money in times of increased interest rates. They already ask the highest interest rates they can to maximise their profits, given the demand for loans (they have to balance what people are willing to pay) and the competition they face with other banks. Canadian banks, for example, don’t face that many competitors at home but they are quite competitive with each other. I know that from personal experience, having taken a loan a few months ago.

I hope that helps you guys understand the role of interest rates in the Economy and why they tend to change. Changes in risk factors are also a very important factor when commercial banks choose their interest rates. Any change in policy, the Central Bank’s main interest rate, or risk in the economy will lead to a change in interest rates for you and firms in that economy.

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