Interesting Interest Rates

Interesting Interest Rates……

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In the News this week, Janet Yellen (federal reserve chairwoman) has again said that the US central bank is likely to increase interest rates. Is this important? Will this affect you?

Now, I have never met Janet Yellen. All I can tell you is that she has blonde hair and likes to wear dark lipstick. I can however, tell you a little about the Federal Reserve. This is the central bank of the US. It is the US equivalent of the Bank of England. So, what is a central bank?

A central bank works for the country. In recent years, it has become acceptable for it to be independent of the government. It manages inflation and financial stability, in other words, it manages the economy. How? Well, that is a whole article in itself (not yet written but I’m working on it!) For now, lets just say that it sets interest rates.

Now, people do not like to be shocked by what central banks do. Just like with the Swiss Pegg (see : https://anneethompson.com/the-mystery-of-money/the-swiss-peg-nothing-to-do-with-clothes-lines/) which changed the markets by 20% in a single day. They therefore usually very carefully give hints, in tightly scripted statements. So, if someone senior (like Janet Yellen) makes a statement – trying to avoid a sudden shock – the market listens very attentively. So should we.

Anyone who is young, may not realise that at the moment interest rates are low. Very low. Possibly the lowest they have ever been. This is due to the financial crisis – the central banks have all lowered interest rates.

I used to own a Mercedes C class coupe. It was beautiful. It drove like a dream. It also had a ‘super charge’ button which I loved (made me feel like James Bond.) When I was stuck behind something slow, I could press my super charge button and whiz past at super fast speed. The central bank, in effect, has a ‘super charge’ button, which is to lower interest rates. If it lowers interest rates people change their behaviour. They are less likely to save (because their savings wont go up in value) it costs less to borrow money, so the population goes shopping. This creates jobs, creates income, leads to economic recovery. For the last five years, every central bank in the world has done this.

However, central banks hate high inflation. Everyone is worse off if there is high inflation. Your money becomes worth less (what you can afford to buy with a pound this year will be less next year) it slows the economy and they do not like it. One thing that encourages high inflation is low interest rates. So central banks want to raise interest rates before this happens.

At the moment, the US economy is going relatively well, which is why the central bank will probably begin to nudge up interest rates, before inflation creeps in.

The other reason is that those ‘super charge’ buttons have been pressed for about five years now. They only really work for giving an extra ‘umph’ when needed, they are a back-up plan. They need to turn them off before we go into a new recession. The central banks need to get everything back to normal (with slightly higher interest rates) so their ‘secret weapon’ can go back into reserve.

How will this affect the UK? Mark Carney (who I have met, at a dinner. He seemed like a very nice chap) is in charge of our central bank. He is saying that “nothing will change for now.” However, he is also saying that if interest rates move it “would be an increase rather than a cut.” These are those carefully scripted hints that we mentioned earlier. People (you and me) need to plan for interest rates to start going up before too long.

Interest rates today are very low. This means that even a small increase has a big impact, even a 1% increase means big changes. For example, if you have borrowed £200,000 for a mortgage you might be paying it back at 2% interest. If interest goes up by 1%, so you are now paying 3%, then your monthly payment would go up by £100. For a normal family, finding an extra £100 every month in order to pay the mortgage, would be hard. Interest rates on other borrowing would also go up. Do you owe money on your credit cards? Have a car loan? Be prepared for the repayments to increase.

We need to be wise, to start planning now for what is likely to happen in the near future. Listen to the hints.

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