INTEREST RATES

What is an interest rate?

When you borrow money, you usually have to pay a fee for the loan. This fee is often called interest, particularly if the fee is proportional to the amount you borrow. It is commonly expressed as a percentage of the size of the loan per unit of time. The interest rate may be fixed or floating. If it’s fixed, you will pay the same percentage for the entire duration of the loan. While with floating interest rate, the interest rate will change regularly depending on market conditions.

Market interest rates

The most important interest rates from a macroeconomic point of view are the interest rates that the government pays on loans they use to finance the national debt. The government borrows by issuing government bonds. All such bonds hae fixed nominal amount and a given maturity date. The government promises to pay exactly the nominal amount, to the holder at the maturity date. Some bonds also promise regular coupon payments at regular intervals.

Relationship between the interest rate and bond price

Note that the interest rate depends on the issue price. Higher the issue price, lower will be the interest rate. If the price of a government bond increases, interest rate falls and vice versa. The price of a bond is usually determined by supply and demand which means you can understand movements in the interest rates by analyzing the market. For e.g. if the government needs to borrow more money, supply increases, bond prices fall and interest rates increase.

Yield curve

The yield curve is the graph of interest rates of different maturity (recalculated to yearly rates)at a particular point in time. If the market expects higher interest rates, then slope of the yield curve will increase. The slope of the curve will turn negative if the market expects the interest rates to fall more than the premium on the longer interest rates.

Other interest rates

Lets discuss the other interest rates that’s available in the market. For e.g. You will earn money when you deposit money in a bank account, and you will pay interest when you borrow money. These interest rates depends on the specifics of the deposits and the perceived risk when you borrow money.

Overnight interest rates

Overnight interest rates are rates for loans over a single night. These are shortest of all interest rates. During the day, banks normally have access to interest free loans from the central bank. At the end of the day, all such loans must be cleared with the central bank. For this reason, there is a market for loans overnight between banks and the overnight interest rate is determined by supply and demand in this market.

Central bank overnight interest rates

The overnight interest rate is an important interest rate for a central bank and it has methods of influencing this rate. In United States, this rate is federal funds rate. If the overnight rate steers away from the federal funds rate, the Federal reserve will take desired action to steer it back towards the federal funds rate.In addition to signaling a desired overnight interest rate, most central banks have standing facilities for overnight loans. The ECB has a deposit facility and a marginal lending facility that member banks use for deposits and for lending overnight. The overnight interest rates must therefore be in between the deposit rate and marginal lending rate.