Interest rates. They are all around us. You turn on the news, you find them. Turn to the financial section in your daily newspaper, you are bound to see something pertaining to interest rates. Try buying a car through a finance house and all you going to hear, besides the over zealous marketing ploys of the salesman off course, is talk of interest rates. At some point in the future when you start feeling like an adult and getting ready to get involved in properties and by extension, mortgages, the interest rate talk will most definitely be one of the deal breakers. Even the most interesting thing that comes out of the reserve bank governor’s mouth is what she intends to do with the interest rates. So this seems pretty important right? You bet your last dollar it is! But the real question is, should you know more about interest rates than you do now? Is knowledge about interest rates really that interesting? Does being well versed in all things prime and repo give you an advantage in making sound personal finance decisions? The short answer is hell yes, but the devil is in the details so let’s take a closer look at the interest rate.
So how exactly did the interest rate come about? Is the origin story vital to it’s understanding? Well, not really so I’m going to outline a quick summary of its history. Like most things numerical, the earliest form of interest rates can be traced back to ancient Greece and Rome. The basic principle that led to the interest rate holds true today as it did back then: one guy needs something that another guy has, and the second guy wants to be rewarded for facilitating the first guy’s needs. So the two guys agree to a periodic accrual system, where the second guy, on top of getting back his initial outlay gets something extra. And that is exactly what interest is. It is a periodic accrual on an investment. Off course, back in the day when people generally had some livestock, a piece of land and a bag of seeds to their name, such an investment was very risky! Hence, the interest rates were very high. But as the riskiness of investments decreased over time due to social stability and security of credit, so did interest rates. So in essence, interest rates are an indicator of risk and profitability. The higher the interest rate, the higher the risk associated with that investment and the more unpredictable the profits from that particular venture. That is all there is to it, well, the extremely dumbed down version that would get any layman’s tail wagging. High risk, high interest rate, high return! That is the central principle in understanding how interest rates work in any context. And how does this central principle fare in the context of the economy? Check out the diagrams below that will help in this regard. The examples and accompanying explanations are based on the South African economy.
The first graph shows the levels of the prime interest rate for South Africa from 2002 to 2014. Clearly it has experienced fluctuations in that period. The second graph shows South Africa’s gross domestic product (GDP), which is an aggregate measure of the economy’s output over the period from 2006 to 2014. The relationship between the two graphs is not apparent at first but if you focus on the extremities, that is, the year 2008 and 2012, you begin to get the picture. In 2008, the South African economy did not have the greatest of GDP’s, therefore an investment in South Africa would have been a very risky prospect. Now look at the prime interest rate for the same year. Very high! In 2012, when the South African economy was at it’s most efficient, churning out output like a well-oiled machine, the prime interest rate was at it’s lowest in a decade! Clearly when the economy was at it’s most profitable, the interest rates where at their lowest. And the opposite holds true. High risk, high interest rate, high return. But off course, this is a bird’s eye view of interest rates, and extremities, although pretty convincing, never tell the whole story! When it comes to setting the prime interest rate, the story gets a little more complicated! So what other factors determine interest rates?
Interest rates are set by the South African Reserve Bank (SARB) as part of the monetary policy of the country. The monetary policy is set by a monetary policy committee (MPC) which consists of 8 members and is chaired by the governor of SARB. The primary function of the committee is to target and regulate inflation (for your own information, this is targeted between 3 and 6%), and one of the tools that they use to fulfill that mandate is regulating interest rates. There is the repurchase (repo) rate, and the prime lending (prime) rate. The MPC sets the repo rate, which is the interest rate it charges banks on the money it lends them. That is currently set at 5.75%. The prime rate is the interest rate banks charge their customers on loans , well more as a reference point more than anything as personal financial risk has to be accounted for as well (this where your credit record comes in). It is currently set at 9.25%. The difference between the two is just good business for banks. Any changes in the repo rate usually trigger changes in the prime rate. A lot of factors determine the level of the rates though, which ranges from the money supply in the country, demand and supply in financial markets, etc. This is the tip of iceberg when it comes to interest rates and monetary policy, but it explains the basic relationship between the economy and interest rates. When the financial section of the news comes about this time and you hear talk of repo rates and prime rates, you will understand at a very basic level what is going on with the economy, with inflation and most importantly, with your own personal finance outlook, vis-a-vis car debt, credit card debt, mortgages e.t.c. So when inflation goes up, not only do the prices of basic commodities go up, but interest rates go up, which means your prime linked loan repayments go up, not because the SARB is trying to take away a few beers from your monthly income, but because they are trying to tackle inflation.
So now when that overzealous salesman is flooding you with the unusually long list of pros of whatever product you are interested in getting, ask him about the interest rates involved, quiz him about the premiums they put on the prime lending rate, gush about the state of the economy and the SARB and how the Greeks and the Romans came up with this system, and maybe, just maybe, he will tell you that he follows conquering finance too! Interest rates are interesting after all!
Check out https://www.resbank.co.za for more information on the monetary policy.
By Nigel Nk.