COLUMN: Taking an interest in the interest rate

By Andre Botha

The buzzword in economic terms are interest rates; especially this week when it’s announced whether the Monetary Policy Committee of the Reserve Bank (MPC) will increase or cut local interest rates. But, let's take a more in-depth look at how interest rates impact the whole economy and what relationships it enjoys.

The first and most important from a South African perspective is the undeniable link between inflation and the interest rate. This link gains more importance in South Africa because of the South African Reserve Bank that follows an inflation targeting approach as its primary monetary policy, trying to keep inflation stable between 3-6%. Currently, inflation is in and around the 5% mark, but with upward pressures in both the fuel price and the currency, it could make this week’s MPC meeting very interesting.

An easy way to understand the relationship between the interest rate and inflation is that when interest rates rise, it dampens inflation – making it an inverse relationship. This is because people and market players will be discouraged to borrow money in a high-interest environment. Everyone will be more inclined to save money, thus diminishing demand. In turn this leads to lower prices as businesses fight for business and vice versa.

Following close on the relationship between the interest rate and inflation is the interest rate and the exchange rate. Unlike the inverse effect that we have seen between the interest rate and inflation, with the exchange rate the relationship is more direct, with a hike in interest rates bringing with it a stronger exchange rate and vice versa.

Graph illustration inverse and direct relationship with interest rates

Foreigners can earn higher profits by investing their money into foreign government bonds with a higher interest rate. To invest the money in those foreign countries, they must purchase the other country’s currency by selling their own, increasing the demand of the foreign currency, and elevating its value.

From the above, we see that the interest rate has an impact on important factors in the market, but it also has an impact on GDP growth. In principle, the interest rate and economic growth should have an inverse relationship. Thus, the higher the interest rate, the lower the disposable income of households and businesses which would lead to lower production which would ultimately lead to lower growth – and the opposite is also true.

The conundrum that the MPC face is whether to sit on its hands on Thursday when making its interest rate decision or to act. Should inflation be a problem, then a hike will be in the offing.

However, this must be done with caution because although a hike will curb inflation in the short term and give the Rand a brief respite, it could also suppress economic growth which will attract the eyes of rating agencies. There is a delicate balance to be struck and this could be an important MPC meeting.

To catch up on today’s market commentary, have a look at the TreasuryONE blog which is updated daily. 

Recent Articles

Featured Changing from one medical scheme to another - effortlessly

It is coming up to the end of the year and you might be looking to change medical schemes, or options within a scheme in preparation for the new year. While you don’t necessarily have to wait for year-end to do so, providers often recommend it.

Read more

Your guide to financially surviving Christmas

There are a few times each year where you need to dig deeper into your pocket and spend more money such as birthdays, anniversaries, and the Christmas period. Whether you celebrate this religious holiday or not, the festive period - depending on how you choose to spend it - means increased travelling, buying of gifts, entertaining, and eating out at restaurants.


Read more

Trump, Trump and a little bit of South Africa

What a November we had, with the rand staging one of its best months and closing below the R14.00 level. To be honest, this looked like quite a far-fetched possibility at one stage during the month. It seems that the tide has changed a little, even though it might be short lived since the US dollar bulls are not so sure of their case anymore.

Read more

Momentum vs. The people: Who is at fault?

This week has seen insurance giant Momentum in the hot seat as debate sparked around its initial refusal of a R2.4 million life insurance pay-out. The deceased was killed in a hijacking but lost the right to claim upon failing to disclose a raised blood sugar condition at the inception of the policy, in 2014. Momentum has since agreed to the pay-out.

Read more

Sign Up

To our weekly newsletter for advice you can bank on

Deals

Free iCollege Scholarship

Price: R600
When: Until 16 May 2019
Where: Nationwide

Telkom December Big Deal

Price: R459 pm
When: Until 31 December
Where: Nationwide

Money Savvy Kids Giveaway

Price: R450
When: 8 December
Where: Johannesburg (Milpark)