Interest rates play a part in all of our lives, whether we like it or not. But what are interest rates and why do they rise and fall? This week’s article explores this principle in more detail:
What are Interest Rates?
You’ll have heard the term ‘interest’ when referring to financial borrowing or saving. If you’re a borrower, the ‘interest rate’ is the amount you’d be charged for borrowing that money. If you’re a saver, the interest rate is the amount you’d acquire in having that amount in the bank’s possession.
What is a Bank Base Rate?
This is often referred to as ‘Bank of England Base Rate’, ‘Official Bank Rate‘ or just ‘the Interest Rate’. These are apparently set 8 times a year (Bank of England), but it was only in August 2018 that the UK saw its rate rise to the highest level in 9 years by a quarter of a percentage point (from 0.5% to 0.75%), (BBC).
The base rate set by The Bank of England is used to set the market for lending. It’s also the rate at which The Bank of England is prepared to make secured loans to government (against gold-plated collateral such as gilts). The Bank of England will intervene in the markets for secured lending to keep the rate for secured lending at that particular rate – they will make unlimited loans available while the market rate is above base, and they will borrow money if the market rate is below base.
In order to understand why we pay more than The Bank of England Base Rate when we borrow and less when we save, we need to understand how this rate is used by our banks. The Base Rate is the rate paid against secured top quality collateral. Our banks then borrow at rates that relate to the inherent risk attached to their lending, over the Base Rate serving as a benchmark. On each transaction, the bank also adds it’s profit margin. So the equation is explained as – the rate the bank can obtain borrowing to lend to you (based on it’s risk), plus an element based on the risk of lending to you, plus their profit.
What influences these rises and falls in interest rates?
Interest rate levels are affected by a few external factors. All play a part in the overall economic sentiment to increase or decrease rates. Here’s a look at the top reasons.
1. Supply and demand
This is one of the main indicators. An increase in the demand for money (or credit) will raise interest rates, meaning market sentiment is positive and people are happy to spend and inject money into the economy. A decrease in the demand for spending will decrease interest rates and lenders often decide to defer the repayment of their loans that would otherwise go back into the economy.
The higher the inflation rate, the more interest rates are likely to rise. Inflation means an increase in the cost of living, as the price of goods and services rise. Lenders will demand higher interest rates as compensation for the decrease in purchasing power of their money they’ll be repaid in future.
The Bank of England controls the money supply, which in turn, influences commercial bank borrowing. They can do this by using interest rises and reductions as a mechanism for managing inflation. If inflation rises above the target levels, the Bank of England is likely to increase rates. Conversely, if it falls below the bank can drop rates to encourage more borrowing and spending.
Sometimes the government spends more money than it earns. This is known as fiscal deficit. To make ends meet, sometimes the government has to borrow money or sell securities, meaning money from the banks is drained. This means there is fewer funds at the banks’ disposal (for lending) which, in turn, forces an interest rate rise.
What does this mean for precious metals?
Rising and higher interest rates maybe bullish for gold prices, simply because they are typically bearish for stocks. “Gold prices increased by more than 150% during 1973 and 1974, at a time when interest rates were rising and the S&P 500 Index dropped by more than 40%,” (Investopedia). As a precious metal investor, it’s important to understand the fundamentals, market forces and terminology. We’d encourage you to use this information, interest rate forcasts and market sentiment to better aid your investment decision-making process.