Interest rates and what they affect

Central bank interest rates are the most watched economic variable, and the mechanisms by which they affect households and markets are worth understanding separately.

What the policy rate is

The rate at which a central bank lends to or pays commercial banks, which influences the rates throughout the economy.

It is set with reference to an inflation target in most developed economies, and in some cases a dual mandate including employment.

Decisions are made by committees at scheduled meetings, with published reasoning and, in several cases, projections.

Markets price expectations of future rates continuously, which means the market response to a decision depends on whether it differs from what was already expected.

The transmission channels

How rates reach the economy.

Borrowing costs: mortgages, business lending, consumer credit — which affects spending and investment decisions.

Savings returns, which affect the incentive to save rather than spend.

Asset prices, since higher rates reduce the present value of future cash flows and make cash and bonds more competitive with equities.

Exchange rates, since relative rates influence currency flows, which affects import prices and export competitiveness.

Confidence and expectations.

And the wealth effect, since changes in asset prices affect spending.

The lag

Which is the most misunderstood feature.

Rate changes affect inflation with a substantial lag, commonly estimated at somewhere between a year and two years.

Which means policy is always being set for conditions that will exist later, based on projections that are frequently wrong.

And it means that policy appears to be responding to conditions that have already changed, which produces a great deal of criticism that does not account for the lag.

The transmission also differs between economies depending on how mortgages are structured — economies with predominantly variable or short-fixed mortgages transmit rate changes to households far faster than those with long fixed terms.

The effect on bonds

The most direct.

Bond prices move inversely to yields, and yields move with rate expectations.

Longer-duration bonds move more.

Which means a rising rate environment produces capital losses on existing bonds, as several bond markets demonstrated in recent years to the surprise of investors who believed bonds were safe.

And it means that after rates have risen, the starting yield on new bond purchases is higher, which improves expected future returns.

The effect on equities

Less direct and more debated.

Higher rates raise the discount rate applied to future earnings, which reduces the present value of companies whose earnings are expected far in the future — which is why long-duration growth companies are typically more rate-sensitive.

Higher rates also raise borrowing costs for companies and reduce consumer demand.

And they make cash and bonds more competitive as alternatives.

Against which the reason rates are rising matters: rates rising because of strong growth is a different environment from rates rising to suppress inflation during weak growth.

The yield curve

Worth understanding.

The relationship between yields at different maturities.

Normally upward-sloping, with longer maturities yielding more to compensate for uncertainty.

An inverted curve, where short rates exceed long rates, has historically preceded recessions in some economies with a variable lag — a relationship that is widely cited and that has produced false signals and is not a timing tool.

It reflects market expectations that rates will fall, which generally implies expectations of weaker growth.

What households should actually do

Practical rather than predictive.

Know when any fixed mortgage deal ends and plan for the reversion, since this is the largest household effect.

Check savings rates periodically, since providers do not pass on increases automatically and the gap between best and worst is substantial.

Recognise that variable borrowing costs change and stress-test affordability accordingly.

Do not restructure a long-term portfolio in response to rate expectations, since these are already priced.

And note that rate cycles are cycles, which means positioning for a permanent state of either high or low rates has historically been a mistake.

What not to conclude

Worth stating.

Rate decisions are widely anticipated, and markets move on the difference between the decision and expectations rather than on the decision itself.

Which means acting on a rate announcement is acting on information already reflected in prices.

And forecasting the rate path is a forecasting exercise with the same poor record as any other, including among central banks themselves, whose own projections are frequently revised substantially.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.