Economies globally are currently gearing gravitating towards higher interest rates. This is seen as a possible solution to the rising rates of inflation. Interest rates have been at historic lows since the global financial crisis of 2008 and are now creeping upwards.
In Kenya, the Central Bank of Kenya raised its benchmark interest rate by 75 basis points to 9.5 percent at its March meeting. In England, interest rates rose for the 11th consecutive time in March 2023. America, too has witnessed a gradual rise in interest rates.
What are the implications of the rising interest rates? According to Bank of America Chief Economist Michael Gapen “Raising interest rates help to cut overall level of demand and therefore, hopefully, reduce the upward pressure on prices.”
One may ask, could this rise in interest rates lead to a recession, or further recession? In the long-run, businesses may respond to consumers purchasing fewer goods and services by reducing production. However, there are many pros and cons to the global rise in interest rates.
If we look at the British scenario, in November 2022, the Bank of England predicted inflation there would peak, and then slowly it would start to fall. It is presumed that headline inflation will continue to fall as pressures from energy and other external costs ease. But are they easing?
The Bank of England has two main jobs; to keep inflation low and to maintain financial stability. Despite recent turmoil and downturn in global markets, the Bank of England governor said inflation remained Britain’s biggest risk. Interest rates were hiked for the 11th time currently at 4.25 percent. This is the highest rate since 2008 and adds to the cost of living pressure for companies and households. But will the rate rise be enough to beat inflation?
Bank of England Governor Andrew Bailey believes interest rates will peak mid-year and, thereafter, gradually come down. The problem is that recent weeks have seen three large global banks collapse, raising the spectre of another financial crisis. Many complaining financial weaknesses was the fault of rapid rate rises across the world and calling for central bankers to ease off. But it is not just the world of finance that is struggling to get to grips with steeper interest rates. Bank of England has stated their expectations to raise the bank rate to 4.5 percent by mid-2023 and the rate will then fall from there to 3.25 percent by 2026.
So that would mean another rate hike before the peak or terminal rate, but for those hoping for rates to suddenly and quickly drop, the drop is not on the immediate horizon. The Bank of England after a further expected marginal rise in interest rate by mid-year, is likely going to keep the whole rate to approximately 4.5 percent for a prolonged period of time as a way to combat the persistent inflation forces.
There are several reasons for inflation especially small open economies that are more exposed to international shock such as the energy crisis. During the Covid era, goods prices were elevated and tradeable products were more exposed to this price volatility. At the end of the day, inflation is about demand and supply. In Kenya, as is the case in the UK, the supply side of the economy remains poor relative to counterparts in the region thereby affecting the long-term inflation outlook.
In the UK, Brexit also has a part to play. There have been studies showing the impact on trade and reduced supply potential of the British economy losing out trading partners due to Brexit. Kenya has been in a predicament due to the fluctuating exchange rates. The currency has weakened amid diminishing foreign-exchange reserves, and a deteriorating balance of payments, compounded with rising global interest rates that have raised the cost of debt servicing.
If we focus on the money markets and investments, there is a relationship between the interest rates and the stock market. The Central Bank changes interest rates to control inflation. Simply put, it increases the rate to decrease money supply. When the interest rates go up it is more expensive to obtain money. The opposite is true as well. When the interest rates go down, it makes borrowing money much easier which leads to more spending.
The United States has the Federal Reserve and other countries have Central Banks that do the same regulating. Interest rate is important, because the prime rate is more or less the same, which is the rate at which the most credit-worthy customers borrow money from commercial banks. The prime rate is what determines the mortgage rate, credit card annual percent rate (APR) and other business loans rates. When the interest rates increase the prime rate also increases which increases the credit card rates, and the mortgage rates.
Since the average individual will pay more for these items, they are left with less disposable income. In other words, the consumer has less money to spend on low-priority items. For instance in tourist destinations such as Kenya, if a hotel chain depends on people to spend on vacation packages, its profits will drop because people are having less disposable income.
Similarly, households will be more reserved on spending which could look like cutting down restaurant bills and careful shopping, but businesses are affected in a more direct way as well. Firms borrow money from banks to expand their operations. When it becomes more costly to borrow, they curb and revise their expansion plans. This slows their growth and industries.
Depending on the business model it might even trigger cutbacks. When these factors reduce the net income of a listed company, its stock price usually is affected and this is how the change in interest-rate impacts the stock market. On a positive note, most blue chip companies listed on the Nairobi Securities Exchange have declared decent final dividends for year-end 2022 which is encouraging for shareholders and should ideally attract investors.
This is a good opportunity for individuals looking to save as the government focuses on strengthening the currency again. Currently given the lucrative Central Bank of Kenya returns on treasury bills and bonds of upto almost 14.4 percent interest per annum as per the most recent Infrastructure Bond issue, there is certainly an incentive to invest in these tools of fixed return as the government works to bring the currency to stability and control inflation.
