Interest rates are constantly changing part of the modern economy. With so many aspects of the world’s finances being dependent on the rate of interest that groups such as the Fed and the World Bank charge, it’s easy to get confused and to begin thinking of interest rates as a mysterious and magical force. However, the following are some of the major causes for interest rate fluctuations, and understanding them is crucial to knowing about the economy.
In a sense, there is a limited amount of money in the world. But in another sense, there is an endless amount of money at the same time. If this sounds complicated, rest assured that it is – the best economic minds in the world constantly wrestle with the money supply. When there’s too much money circulating, interest rates need to be high so that borrowing doesn’t spiral out of control. However, when the money supply is tighter, lower interest rates are a useful way to stimulate borrowing.
Human beings have certain tendencies, such as to save money when they receive a substantial amount and to spend money when they receive it in small doses. However, the savings rate across a region is not a fixed or static variable.
When savings rates go up, borrowing is not as necessary for consumer spending and interest rates tend to lower to compensate for this. When savings rates drop, borrowing becomes an even more necessary part of the consumption process and interest rates are generally raised to keep things reasonable.
The bond market is the law of the land when it comes to debt. When a nation issues more debt in its government’s name, it often has to create more money to offset this debt. This expands the money supply, which in turn tends to result in interest rates being driven upward as a matter of economic policy and trying to keep the borrowing rate rational.
When the bond market is hungry to buy the bonds that a government issues, this tends to raise the money supply. However, when the bond market is less interested the money supply tends to either stagnate or decrease, which tends to pressure interest rates to go downward. Sure, understanding the bond market isn’t as easy as just following a ticker and reading a few charts, but with time and continued reading it’ll make more sense.
Investor Risk Tolerance
Investors are human beings, and human beings are not always rational creatures. While the notion of what leads to both “good” and “bad” economic times is open for debate, what’s easy to tell is when investors fear losing what they have within the paper asset markets. This fear of loss tends to stimulate the bond market, which in turn tends to lower interest rates because bond buyers are willing to settle for less than they otherwise would. When times are better, investors are more concerned about making money, so those who buy bonds expect to receive greater interest.
Translate Knowledge to Your Business
With this base understanding of interest rates, knowing when and where to borrow has become a bit simpler. Look for a time when savings rates are high to fund a new renovation, business expansion, or second location, as the loan rate will be at it’s lowest. Take a look at historical trends on both savings rates and interest rates, and you will see that there is a pattern that they follow based on the time of year. Plan out your next big investment during a time when your company can get a historically low rate, and you’ll be glad you did your homework!
Interest rates are a complicated thing. But they are reasonably easy to understand if you know the forces behind them.
Image via Flickr by epsos.de