FOOL'S EYE VIEW
Interest Rates

By Alan Oscroft
January 4, 2001

Liverpool -- It can't have gone unnoticed that US interest rates have been unexpectedly cut, by 0.5 percentage points, and that is likely to be reflected by an interest rate cut here in the UK in due course. But what difference does a change in interest rates actually make?

It's All About Consumption

Economies grow, and getting them to grow at a long-term sustainable rate is a tricky business. Economic booms and busts, of the kind that plagued the eighties, cause a lot of pain and are to be avoided at all costs. The expansion of an economy is driven by consumer spending, and consumer spending is the ultimate source of all profits made by companies for their shareholders. But too much consumer spending is bad too, because that drives inflation to undesirable levels.

How Is It Controlled?

The interest rate provides the only real tool that a central bank has for controlling the level of consumer spending. If an economy is starting to overheat and inflation is rearing its head, a rise in interest rates can help to slow down consumer spending in two ways. Firstly, it increases the cost of borrowing money, which in turn leaves people with less cash to spend after paying their mortgages, car loans, and other borrowings. A lot of consumer spending is itself directly financed by borrowed money, and that becomes less attractive too.

Secondly, an interest rate rise increases the returns that savers get on their savings, making saving that bit more attractive compared to spending. The same thing happens to companies too -- when debt becomes more expensive to service because of higher interest rates, profits fall and plans for expansion and the like might be put on hold until more favourable times.

The opposite happens when an economy is slowing. Lowering interest rates makes borrowing cheaper. Consumers have more spare cash to spend, companies can raise cheaper capital, and the economy starts to accelerate again.

And For Investments?

Interest rates clearly have an effect on the profitability of companies. Higher interest rates mean lower consumer spending and a higher cost of capital, and that means a slowdown in profits. Lower interest rates, on the other hand, stimulate consumer spending and lower the cost of capital, boosting profits.

That's the main economic effect, but there is an extra effect generated by the way the investment industry works. Institutional investors tend to put their eggs in a number of different baskets, including shares, gilts, and other bonds. Gilts and bonds are loans, with the investor lending money to governments and companies respectively, and the return paid on them depends on the interest rate at the time -- gilts issued when interest rates are low won't pay as much as those issued when rates are high.

Gilts are generally seen to be zero-risk investments, because governments in the developed world are just not going to default on them (Russia maybe, but not the USA). So, while the return on gilts is low relative to shares, it is a very safe and predictable return.

The Equity Risk Premium

The return from shares, by comparison, is far from guaranteed and is by no means zero risk. To be attractive and to compensate for the extra risk, shares must return a premium over gilts, and that extra is known as the "equity risk premium". Its specific level is the source of endless academic debate.

When interest rates rise, the return on gilts also rises, but the return on shares is expected to fall as economic expansion slows. As the premium expected from shares falls, institutional investors shift some of their funds from shares into gilts and bonds, causing a fall in the stock market.

The converse, which we have seen today, happens when interest rates fall. Gilts then become less attractive and the return from shares is expected to rise due to the economic boost generated by the rate cut. That causes institutional investors to shift some money out of gilts and into shares, bringing about a rise in the stock market.

What Should We Do?

How much should this affect the way private investors go about their business? A cut in interest rates can offer opportunities for refinancing those long term loans such as mortgages, and sensible remortgaging over your house-buying lifetime can have a significant effect on the final price you pay to keep the rain off.

As far as investments go, though, changes in interest rates matter little to a long-term investor, and the only thing we can safely say about interest rates over the long term is that they will fluctuate. If you keep your money in high quality shares bought at sensible valuations, you can rest safe in the knowledge that you are in the best form of  investment that we have seen in the last century, and are likely to see in this one.

Where Next?

The US Fool on the interest rate cut 
The Fool's Mortgage Centre
Economic Analysis discussion board