Rating the Rates

When the news flash commentators talk about the ticks in the rates in an economy, which are the types of interest rates that come to a general citizen’s mind?

In its simplest interpretation, interest rate is an agreement between a borrower and a lender of funds. In an economy, an individual, a partnership of individuals, a private limited company, a small or a large corporation in private or public sector, a small or a large bank, the government and the central bank, all of them can act as lenders or borrowers. At a point in time, these entities would be willing to lend (or borrow) an amount of fund, only for a certain term length of few days, weeks, or months, to some years.

The borrower who is in need of funds, will see this agreed interest rate as a cost of acquiring the funds now (or rights to acquire funds in future). The lender of funds will be looking at the agreed rate as returns (yield) generated from taking the risk of lending. The cost of funds (or the interest rate) to a borrower, is the yield rate (or returns) to the lender.

The agreeable term period of time for which the fund can be borrowed or lent by the two parties, is crucial in determining that value of the interest rate or yield rate. If we keep the value of the rate fixed, the borrower would want to borrow the funds for as long term as possible. At the same time, for a given yield, the lender would like to lend for as short term as possible. This is the general liquidity preference theory. Hence, this desirable ‘duration’ mismatch between the borrower and lender causes the value of interest rates to have a ‘term-structure’ for different maturity terms. By the above logic, the term structure of rates should in general be upward sloping, which is actually the case in general times i.e. The interest rates (or yield rates) for longer maturities are generally higher than for shorter maturities.

Another factor for coming to the agreeable rate between the lender and the borrower is their expectations of inflation level in the economy. If the lenders anticipate higher inflation, they would be looking for higher nominal yields from their lending activities.

The agreeable value of the rate will also depend on the credibility of the borrower. The possibility of defaulting on the obligation to payback the borrowed funds, will cause the cost of funds (interest rates) to be higher for the borrower. The credibilty will be in a good standing if the borrower can pledge quality assets against the borrowed fund obligation. Hence, the agreed rates for secured (pledged collateral from the borrowing party) lending will be lower than the case for unsecured lending.

To influence the agreeable rates between parties, and hence the ease of availability of funds, the central banks are vested with the authority to push the money-gas for accelleration of economic activities or pull some brakes to slowdown the soaring of inflation levels. The board of governors of the central bank, appointed by the government, are given the mandate to play a balancing act with three items: the economic growth, the level of inflation and the proportion of unmployment in the population. In the game-kit for playing the balancing act, one of the tools available to the central bank is to prescribe (as a policy rate) the target range of interest rate for overnight lending (or borrowing) between banks/depository institutions for their purpose of maintaining the required level of reserves with the central bank, in order to uphold the license to accept deposits from the citizens.