All Terrain Thinking

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"If you teach a man to think he is thinking, he will love you. If you teach a man to think, he will hate you. - Ed McArthur"
 
 

Economics: It's not just whats' in your wallet

A Primer on Interest Rates

For those of you who have paid for your tuition with a student loan, your clothes with a credit card, and your car with a car loan, as well as those of you grew up in a home that was purchased with a mortgage, interest rates matter. They also matter to those of you who may have some savings in a bank account, some money invested in the stock market, or some friends or family that are employed in the construction business. If interest rates rise, you are likely to feel the negative effect if you are borrowing money, and the positive effect if you are lending money since you will be paying more for your car loan and earning more on your bank account.  When interest rates change, there are winners and losers.

To fully understand interest rates you would need to invest a considerable amount of your time learning about the details of the capital market, but fortunately you can gain considerable insight into interest rates with a modest investment. As you read about interest rates in the financial press, you should keep three points in mind - interest rates are prices, there are many interest rates that tend to move together, and there are many components to each interest rate. In this section we will discuss these three points plus briefly describe the history of interest rates in the past thirty-forty years. 

Interest rates are prices.

A starting point in an analysis of interest rates should be the recognition that the interest rate is a price, and the model of prices we discussed earlier is an appropriate framework to analyze prices. We will not embark on an extensive review of the Supply and Demand model of prices, but you might recall the questions in the cookbook approach which are relevant for any analysis of interest rates.

  • Identify the market (is it a home mortgage or CD rate?)
  • Identify the participants (who are the suppliers and demanders?)
  • Identify the determinants of behavior (what affects the suppliers and the demanders?
  • Identify the appropriate curves to represent the behavior

Once you look at interest rates as the price of funds, you can see how the Fed can affect interest rates through its control of the money supply - but more about that in our discussion of the 1970s. 

There are many interest rates, but they tend to move together.

When we talk about interest rates, we seldom talk about specific rates, although what you care about are the specific rates. You care about the rates on your loan or your bank account, while policy makers may care about the government pays on it's debt. The good news is that they are all closely related.  Because interest rates tend to move together, although the fit is not a perfect one, we will simply talk about interest rates. When we talk about rising interest rates you should expect to see your loan and bank account rates rising. The relationship between various interest rates is evident in the graph below.  Interest rates on loans to local governments (Municipals), low risk corporations (Aaa bonds), and the federal government (Treasury 10 year bonds) tend to move together.

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There are a few rates you may want to know about as you sort through the financial press, rates that we will talk about later.

  • Discount rate: rate that the FED charges banks for overnight borrowing
  • Federal funds rate: rate banks charge other banks for overnight borrowing
  • Prime rate: the rate banks charge their 'best' customers
  • T-bill rate: the rate on short-term (<1 year) on government securities
  • Mortgage rate: the rate on home loans, car loans

There are many components to each interest rate.

When you see an interest rate you should think of that rate as the price of borrowing / lending a specific asset.  For example, is a 20 Watt CD player the same as a 100 Watt player? Is a two bedroom apartment overlooking the water the same as a studio apartment with a view of the next building? Experience has shown that students have no problems seeing the differences between the CD players and the apartments and in predicting differences in prices. With a CD player, one would be willing to pay for more power, while for apartments, we would pay more for the view.

The same is true with interest rates. An interest rate is the price of borrowing, and not all borrowing is the same. For example, you would charge less to a borrower who you were confident could repay the loan, and you would charge more if you expected dollars to be worth less when the loan was repaid. When you look at interest rates, therefore, you should think of them as reflecting a number of important criteria that affect the lenders decisions. One such set of criteria appear below. The interest rate quoted to you (r) can be decomposed into five separate components. [For a more detailed treatment you can  fast-forward to our discussion of rates in the 1970s.  Here you will find a more detailed treatment of the inflation effect, the default effect, and the maturity effect. At this time, however, you need not look at these links]. .

r = rr +ri + rd + rl + rm

where

  • r = nominal rate (quoted rate - what you see in print)
  • rr =  (rate in MS-Md graphs)
  • ri = inflation effect
  • rd = default risk effect
  • rl = liquidity effect
  • rm = maturity effect

OR

where

In our discussion of interest rates, we will be talking about rr, the real risk-free rate of interest.  You can think of this as the measure of the relative scarcity of funds and that all other interest rates are based on this rate.

The actual rate of interest you see in the financial press, or hear from your banks, is r and it differs from the core rate to reflect four important aspects of the transaction that affect the lender's perception of risk.  Riskier loans carrying a higher interest rate since if you are to be coaxed into lending money to a riskier venture, it will only be if you are offered a premium to compensate you for your greater level of anxiety over the likelihood of repayment. Rates also reflect tax policies. For example, consider the rates on municipal bonds which are tax exempt. The tax exempt status of municipal bonds means the purchaser of that bond will not have to pay taxes on the interest income. If a person were in a 33 percent tax bracket, then this person would be indifferent between receiving a taxable interest rate of 9 percent, which would produce an after tax return of 6 percent 9(1 - .33), and a tax free rate of 6 percent.

What are the determinants of one's perception of risk? First, there is the ability of the borrower to pay back the money - default risk. This is why bond rating companies are so important. Bond rating companies examine the income and balance sheets of the potential borrowers to determine the fiscal health of the potential borrower. If the bond rating for a state or company drops because the rating company has questions about the state's or company's ability to repay the loan, the interest rate will rise, raising the cost of borrowing. The difference between corporate Aaa bonds and federal government bonds can be in large part attributed to the market assuming that the default risk for corporations is higher than it is for the government.

Interest rates are also influenced by the ease with which a lender can recoup its losses in the event that the borrower can not meet the repayment schedule. Generally speaking, interest rates are lower when the borrower offers more collateral, assets to be taken over by the lender in the case of default. This is why the rate on home mortgages are lower than car loans which in turn are lower than the rate on personal loans. This is another component of default risk.

Time to maturity is an additional source of risk. Given our inability to accurately predict far into the future, anyone lending money for a long period of time will generally require a higher rate of return to compensate for the higher perceived risk - maturity effect. This feature of interest rates is clearly evident in the diagram below. The rate on long-term 10 year bonds are substantially higher than the rate on 6 month bonds because of the greater risk. There are, however, times when the pattern is reversed,  but any discussion of the reversal will be pushed to the 1970s. 

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Interest rates are also influenced by inflation rates.  The time-series diagram below clearly indicates a positive relationship between interest rates and the inflation rate.  As you would expect, when lenders see higher inflation rates they will want to receive higher returns on their loans and borrowers will be willing to pay higher rates because the dollars when they are repaid are not worth as much as when the dollars were lent out.

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In the 1950s when the average inflation rate was 2.03 percent, the nominal rate on 3-month government securities averaged 2.03 percent.  By the 1970s, however, inflation averaging 7.2% drove nominal interest rates higher - to 6.3% percent for 3-month government securities. In the 1980s, we saw a reversal of the trend as interest rates tended to follow inflation rates lower.

But what about real interest rates? Does the capital market adjust quickly so real interest rates remain constant?  As you can see from the following diagram, information on nominal interest rates is not always a good indicator of the value of real interest rates.  In the diagram below we see the real rate on short-term government securities, where the real rate is defined as the actual rate - the actual inflation rate.

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In the late 1970s real interest rates turned negative as lenders took a beating because the interest rate increases did not keep up with spiraling, unanticipated inflation. As a result of the recessions in 1980-1982, inflation dropped sharply, but interest rate declines failed to fully reflect the disinflation. A substantial rise in real interest rates was the result. In the 1980s, the real interest rate on 3 month government securities rose nearly 5 percentage points - a pattern we saw duplicated in the recession of 1990-1992.  

The second feature of the interest rate graphs is the apparent break in the upward trend which occurred in the early 1980s. There were two events in the 1970s which helped push up the inflation rate into double digit ranges. The first were the two OPEC price increases which put extreme upward pressure on prices as firms attempted to raise their prices to compensate for their increased energy costs. The second was the freeing of the world's monetary authorities from any external constraints as the world went off the gold standard. For the first time in the post W.W.II period, monetary authorities of all countries were free to print as much money as they desired. The result was a surge of the world's money supply which was quickly reflected in higher price levels and inflation rates. The dramatic break in the inflation rates in the early 1980s was the result of a change in policy at the FED, the U.S. central bank, and a decline in world oil prices accompanying the recession of the early 1980s.

We have now finished an overview of the capital market including a discussion of interest rates.  It is now time to move on to the last market, the foreign exchange market. 

Why do interest rates differ?

 
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