What is the relationship between interest rate and interest?
But have you ever thought about it? Why is interest rate so important? Is it decided by the central bank or the market? Why cutting interest rates can stimulate the economy? Why must interest rates be raised when inflation occurs? What is the relationship between interest rates and the stock market?
I personally think this is the most important concept in economics, interest rate. How is this going?
Interest rate, this is a very big topic, and it is a concept of interest rate that people often confuse. So today I will talk about it first, and let’s clarify the underlying logic together.
Interest rate is also called interest, and everyone is more or less exposed to it. For example, if the interest rate is 2%, you can deposit 100 in the bank this year and get 102 next year. You want to borrow money from the bank and you have to pay back 102 next year. You can understand the interest rate as the time cost of money. 100 this year is equivalent to 102 next year. Why is interest rate so important? Let’s simplify this problem first. We assume that all interest rates in the economy are the same, that is, no matter deposits or loans, no matter who I borrow or who borrows from whom, whether you save for a few years or 10 years, all interest rates are the same.
Okay, if I lower the interest rate from 2% to 0, assuming all other conditions remain unchanged, what will happen? In this economy, rich people will lose interest at first glance, right? I might as well buy a house, a car, a bag, or invest in opening an online store or restaurant. In short, it will reduce saving and increase consumption and investment.
At the same time, when everyone saw that the loans had zero interest rates, they didn’t spread the loans, right? Companies will borrow money to expand production, hire people, promote, invest, etc. Compared with the 2% interest rate just now, everyone will borrow more money, invest more, and consume more. Many people will take out loans to buy houses, and the seller has more money. The seller will buy a car, the seller will have money, the seller will buy a bag, the seller will have more money, and the seller will buy a house.
So central banks in various countries are also well aware of this. As soon as there is any trouble in the economy, they immediately cut interest rates to stimulate the economy. For example, in 2020, the Federal Reserve has just prepared to raise interest rates. As soon as the epidemic hit, interest rates were immediately cut to stimulate the economy, not to mention that Europe and Japan have already begun to cut interest rates to stimulate the economy.
When interest rates drop from 2% to 0, the overall economy becomes more active, unemployment is lower, and everyone is wealthier. But then, companies will find that there are more and more wealthy people and the demand is getting stronger and stronger. Should the price of the bags being sold be increased? Not only bags have gone up, consumer goods have also gone up, and raw materials such as leather machines have also gone up. In the end, everyone's wages will go up, which will lead to inflation.
On the other hand, the effect of raising interest rates is also corresponding. It will suppress the economy in the short term and suppress inflation in the long term. That's why the United States and Europe have had high inflation recently, so they immediately started raising interest rates, or were preparing to do so. So, you see, just now, we have analyzed such a large transaction. In fact, what we want to say is the most basic and critical conclusion that you must know. Cutting interest rates can stimulate the economy in the short term, which is what we often call stepping on the accelerator of the economy, but in the long term.
Let’s take a look at some of the news we usually hear. The Federal Reserve raised interest rates by 50 basis points in May, the European Central Bank plans to raise interest rates for the first time in July, the United Kingdom raised interest rates for the fourth time by 25 basis points to 1%, and Ma Yang began to cut interest rates in 2023. What interest rates do you think this central bank controls? Are they the one-year, five-year, and ten-year deposit interest rates we usually see in banks? No, for example, I took a loan from a bank to buy a house. For a 10-year loan, the bank asked me for an interest rate of 5%. Why would he want 5%, right?
What do banks think? Let’s break it down. There are three main parts here. The first part is called the risk-free rate. Let's assume, say, 3%, the second part is the risk premium, say 1.8%, and the third part is the bank's profit, say 0.2%. These three parts plus one are the 5% you can see.
He is a completely risk-free person. To put it bluntly, it is the interest rate required for his loan. In real life, the closest thing to risk-free is the government. Of course, governments in larger economies can be considered approximately risk-free. The interest rates corresponding to bonds issued by these countries, such as Chinese treasury bonds, U.S. treasury bonds, Japanese treasury bonds, and German treasury bonds, can be approximately regarded as the risk-free interest rate of the corresponding currency. These government bonds can be freely traded in the secondary market.
For example, the latest price of the 10-year U.S. Treasury bond is 100.5312. We can calculate that its corresponding interest rate is 2.814%. This is the interest rate of the 10-year U.S. Treasury bond, which is the interest rate of the 10-year U.S. Treasury bond. Risk interest rate, so you can see that each period of money corresponds to a risk-free interest rate, such as the 30-year Treasury bond interest rate, the 10-year Treasury bond interest rate, the 5-year Treasury bond interest rate for 3 months, etc. We can draw these risk-free interest rates on a graph with the horizontal axis as time, which will form a curve, which becomes the risk-free interest rate curve of money, called the yield curve.
So the core interest rate in an economy is not a number, but a curve, and this curve is the benchmark for the entire economy and the foundation of the economy.
Typically, this curve is upward sloping, meaning that long-term interest rates are higher than short-term interest rates. Sometimes you'll see an economy's medium- and long-term interest rates be lower than short-term interest rates.