The Macroeconomics of Interest Rates

Today we’ll delve into a slightly more difficult topic. Macroeconomics. Slightly more difficult, but very important. There’s a famous financial blogger (whom I can’t name here, cause I forgot who…) came up with this insight: “Of all financial education taught, macroeconomics is the one which most people have no knowledge about, yet is the most relevant and most useful.”. Let me explain why.

Let’s start with interest rate. For most people, interest rate is important as a hedge against inflation.

Actually, let’s rewind that. For most people, interest rate is important as a no-risk way of growing their money. However, if we put interest rate:

interest-rate

together with inflation rate:

inflation

we get “REAL” interest rate:

real-interest-rates

Which is the ‘real’ rate that your money is growing in a Fixed Deposit account.

In fact, we can see two trends in the graph above:

real-interest-rates-copy

If you are an older person who experienced high interest rates before, you would have the experience of the green part of the graph, where you indeed do grow your money from interest rate.

If you are a younger person who only experienced low interest rates, you would have the experience of the red part of the graph, where your money in FD is just hedging against inflation.

So for most people who are around long enough to have significant money in FD, they would therefore think that FD grows your money.

So part of your belief system about interest rates will be influenced by your experience of the economic system.

But in macroeconomics, what we believe or don’t believe is useless in deciding whether FD can still be used to grow our money. There are in fact, real world circumstances that caused the current low real interest rate environment. If we understand the big picture, we can make an informed decision of how to position our money. Will there be continued low real interest rate or will it reverse higher?

First is the current level of economic growth. Interest rate is used to influence economic growth. If economic growth is slow, interest rate can be reduced to encourage people to borrow money to increase economic activity. If the economy is getting hot, interest rate can be increased to encourage people to pay back loans and reduce their economic activity. Current economy is slow, so interest rate is also low.

Secondly, interest rate is used to control inflation. Inflation happens when there is too much money around, buying the same amount of stuff. But currently inflation is low, so interest rates is also set low.

Thirdly, there is too much debt in the world now. Whether its from people or government, there are a lot of people borrowing money. These money will need to be paid back eventually. One way government pay back their debt is to ‘inflate’ their debt away. What this means is that they let inflation rise higher than the interest rate. So example the 1 ringgit the government promised to pay the lender tomorrow is actually lower than the value of 1 ringgit today. So the government all around the world have incentive to set interest rate low. 

In fact, there are governments in the world that set negative interest rates. Which means you actually pay the bank to take care of your money, how crazy is that? But this is the situation in the world now. It is not that government do not recognize that people who saved money in the bank is seeing their hard earn money erode away. But the combination of factors above, together with aging population, excess capacity and growing wealth inequality (less disposable income spending by the group with the highest proportion of consumption spending) means low real interest will remain lower for longer. 

So by understanding these macroeconomic conditions, we can then make an informed decision on how to position our portfolio accordingly. 

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