HERE’S a challenging icebreaking question I sometimes use when discussing matters with potential clients: “Do you know why central banks like the United States Federal Reserve (the Fed), the Bank of England (BoE), and our own Bank Negara Malaysia (BNM) sometimes raise interest rates over long stretches of time?”
I’ve been surprised by the high number of otherwise well-informed professionals and business owners who aren’t sure about this. So, here are four reasons a country’s, or even an entire region’s central bank (like the European Central Bank or ECB), may go through a so-called “tightening cycle”:
1. To cool down an overheating economy;
2. To increase incentives for saving money;
3. To reduce drivers for borrowing money; and
4. To strengthen its domestic currency.
At the heart of all four of those reasons is the overarching goal of reducing inflation rates to a low, yet still positive level.
When we ride a bicycle or drive a car, we quickly learn to apply the correct degree of pressure to slow down or bring our ride to a full stop. The parallels between decelerating a single vehicle and slowing down an entire economy become apparent when we exercise our imaginations.
If a car’s engine is revved up to run at ever higher revolutions per minute (RPM) until it starts redlining, that situation is:
1. Bad for engine health; and
2. A precursor to rapid piston meltdown and damage, which will destroy the engine.
When we go on a road trip, we usually wish to travel safely over long distances, not dangerously and frenetically for a short time. We want to let our car run optimally in a manner that extends engine life and maintains high performance.
Similarly, when the overall economy of a nation or integrated region needs to be kept humming along for many years, that economy cannot be permitted to overheat or figuratively redline. Just as we release the accelerator to reduce engine RPM and tap on the brakes to slow down a speeding car; in an economic area, we need to figure out how to lower its inflation rate.
TAPPING THE BRAKES
Inflation reflects rising prices that are often fuelled by too much money cycling through an economy chasing steady quantities of services and finished goods per unit time, usually over a year. So, as mentioned, central banks raise interest rates to:
1. Cool down an overheating economy;
2. Increase incentives for saving money;
3. Reduce drivers for borrowing money; and
4. Strengthen domestic currency.
For most central banks, persistent annual inflation running in the five per cent to, say, 15 per cent or beyond range is too high. The long-term target rate by all central banks nowadays is a seemingly arbitrary two per cent a year.
So, if a country’s or region’s annual inflation rate is perhaps eight per cent, its central bank figuratively taps the brakes of its economy by bumping up its primary benchmark interest rate from which all other interest rates there take their lead.
The US benchmark rate is the Federal Funds Rate (usually called the Fed Funds Rate), while Malaysia’s is BNM’s Overnight Policy Rate (OPR).
Central banks can lower the temperature of their economies, which are running too hot, through the blunt yet powerful monetary policy tool of interest rate increases.
RISING INTEREST RATE
For consumers and businesses with excess cash, a rising interest rate environment makes it compelling to save more money. When that happens, money is sucked out from the free-flowing cash flow currents of the economy. This drops the volume of cash chasing goods and services. The net effect is a lowering of inflationary pressures.
At the same time, a ratcheting up of interest rates makes it more expensive for consumers, businesses, and even the government to borrow money for consumption or development.
A reduction of borrowings limits the expansion of credit in that economy. Again, this tends to reduce the volume of cash spinning through the area each year, and thus tamps down on its aggregate inflation rate.
Finally, when interest rates in a country go up, then the attractiveness of parking international hot money — cash that scours the world, chasing ever better yields — in that country’s currency (or its assets) grows.
FIGHTING INFLATION
The ensuing rising tide of buying pressure in the domestic currency — say the US dollar for the US or the ringgit for Malaysia — causes that currency to strengthen against other currencies.
When a country’s domestic currency grows stronger, imports into that country become cheaper. This has the equally valuable effect of reducing the cost (in the domestic currency, say ringgit for us in Malaysia) of imports. Incidentally, that is how Singapore uses its robust currency, the Singapore dollar, to curb imported inflation.
So, all told, the key reason central banks raise interest rates is to fight inflation. Doing so is often one of two of their common mandates:
1. Controlling inflation and keeping it steady at a healthy two per cent a year rate; and
2. Keeping unemployment low.
Now that you know all this, take time to figure out how to profit from your knowledge.
Source : New Straits Times
