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Interest Rates Explained : How central banks can move markets with one decision
You may have heard about the term “interest rates” in the news lately. If you are unsure what that means, check out this article as we explain what these key “interest rates” refer to, and why a single decision on setting the rate has huge ramifications on the economy at large.
In simple terms, an interest rate is the amount charged on top of the principal by a lender to a borrower.
The interest rate that the finance world is interested in is a “bank rate”. In Malaysia, it’s known as the “Overnight Policy Rate”, which is the interest rate set by our central bank, Bank Negara Malaysia (BNM).
BNM determines the rate of interest for financial institutions that lend each other money overnight.
But how does BNM determine this “bank rate”?
In the short run, if the Monetary Policy Committee (MPC) of BNM wishes to decrease the interest rate, it engages in expansionary monetary policy.
Essentially, the central bank increases the “supply of money” in the economy by purchasing bonds from the open market. All things being equal, an increase in the money supply leads to a fall in interest rates.
In 2020 itself, BNM cut the OPR rate 4 times, the timeline is:
- 22nd January 2020 — OPR rate cut by 25bps to 2.75%
- 3rd March 2020 — OPR rate cut by 25bps to 2.50%
- 5th May 2020 — OPR rate cut by 50bps to 2.00%
- 7th July 2020 — OPR rate cut by 25bps to 1.75%, the lowest level on record
But why would Bank Negara want to set a “high” or “low” interest rate?
A low interest rate could increase consumption. If the interest rate is lower, loans are cheaper. People are more willing to take out loans to make big purchases such as houses or cars. A low interest rate could mean businesses take out more loans to purchase new machines, which could reduce costs, which in turn increases their profits. It could even affect the exchange rate. Ceteris Paribus, say if the Malaysian interest rate is lowered, there would be “hot money outflows”.
Say foreigners take their money “saved up” elsewhere and out of the country, due to a decrease in the incentive to save as the interest rate is lower. With foreigners “selling” the Malaysian Ringgit (as they convert it to their home currency), the Malaysian currency would weaken under the selling pressure. This may not be all bad, as a “weaker” currency makes Malaysian exports more attractive as they are cheaper.
All of these points sound good, so why don’t the central banks keep interest rates low all the time?
The aforementioned points are simply “theoretical”. The economy could “overheat” if interest rates are too low. There is a general tendency for interest rates and the rate of inflation to have an inverse relationship.
In general, when interest rates are low, the economy grows, and inflation increases. With inflation, which is the steady rise of prices for goods and services over a period, it erodes consumer purchasing power. In other words, we become poorer because our money is worth less every year.
In summary, interest rates are one of the most important aspects of the economic system. They affect consumers, businesses and foreigners alike.
As the world battles escalating inflation pressures due to interest rates at an all time low, most analysts expect central banks across the globe to increase the interest rate. With the rise in interest rates, you should expect to see increased cost of borrowing, followed by reduced investments. However, there is also an increased incentive to save rather than spend. Higher interest rates make it more attractive to save in a deposit account because of the interest gained.
Property Guru. 2021. Overnight Policy Rate (OPR) In Malaysia: Why It’s So Important. [online] Available at: <https://www.propertyguru.com.my/property-guides/what-is-opr-overnight-policy-rate-malaysia-14728> [Accessed 1 December 2021].
Bankofengland.co.uk. 2021. Interest rates and Bank Rate. [online] Available at: <https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate> [Accessed 1 December 2021].
Researcher(s): Vanessa Wong
Reviewer(s): Muhammad Bahari
Editor(s): Johanna Lok
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