What Is an Interest Rate?

Interest rate (English: percent rate) – this is the percentage charged by a lender for the use of borrowed funds. The calculation period of the rate varies and is set separately in the contract, usually it is a month, quarter or year.

What Are the Different Types of Interest Rates?

There are:

Illustration: What Is an Interest Rate?

central bank interest rates,
loan operations of financial institutions with non-bank clients,
the yield of securities (for example, bonds)
and so on.

Interest rate can be real, i.e., adjusted for inflation, or nominal, which takes into account the level of inflation. Fixed rates are also distinguished, which do not change throughout the contract, and floating interest rates, which are reviewed at regular intervals. The latter includes the LIBOR (London Interbank Offered Rate) interest rate.

How Does an Interest Rate Affect the Economy?

Illustration: What Is an Interest Rate?

The level of the interest rate, set by the Central Bank, is an important indicator of the country’s economic stability, as it is a tool of monetary policy. The higher it is, the greater the investment interest of foreign investors and more their investments in the national economy. For the internal economy, a high interest rate means a reduction in loan amounts, which does not always have a positive effect on development, but slows down inflationary processes.

How Do Interest Rates Affect the Forex Market?

The difference between interest rates of central banks (interest rate differential) plays a key role in forming the exchange rate. An increase in the rate is seen by investors as an opportunity to get risk-free income and causes increased demand for the national currency. Conversely, a decrease leads to capital outflow from the country’s economy and, as a result, weakens the national currency.

In modern conditions, central banks use the method of regulating interest rates to influence the exchange rate of the national currency (in addition to currency interventions). There are many types of interest rates, but for the foreign exchange market, the official and banking interest rates are most interesting.

Official interest rate – this is the rate at which commercial banks borrow money from the central bank.

Banking interest rate – this is the amount the bank charges for the use of a loan, expressed as a percentage.

All types of rates are interconnected and determined by the official one, which central banks set in their countries.

Lowering interest rates leads to increased business activity and increases inflation, while the national currency rate decreases.
Raising interest rates in turn leads to a decrease in business activity, a decrease in inflation, and an increase in the exchange rate.

Because of this relationship, we have the following pattern: the higher the official interest rate in a country, the more people want to buy its currency to deposit money at a higher rate, meaning the currency’s value increases.

For example, at the end of 2015, the Fed rate was 0.25% with the prospect of an increase, while the ECB rate was 0.05% with the prospect of further easing of monetary policy, which became the reason for the prolonged decline of the EUR/USD currency pair.

Depending on the characteristics of the state economy, the CB, by changing the level of the interest rate, performs functions of inflation control, deflation, support or slowing down of economic growth.

The results of the CB meetings on monetary policy, where decisions on the size of the interest rate are made, are the most important events in the economic calendar and cause increased volatility on the Forex in the corresponding currency pairs.

Interest Rates of the Largest Central Banks in the World

Illustration: What Is an Interest Rate?

Federal Reserve (U.S.) – Target Fed Fund Rate. The main interest rate in the U.S. is set by the Federal Open Market Committee (FOMC). It is called “the target federal funds rate” and is the main global interest rate.
European Central Bank (ECB) – Refinancing tender. This is the equivalent of the American Target Fed Fund Rate. The European refinancing rate is the minimum possible rate for applications to raise funds within the ECB tender. Every two weeks, to support liquidity in the financial system, the European regulator conducts a tender for the placement of funds. In other words, this is the minimum rate at which ECB transactions take place on the open market. Refinancing tender is the second most significant interest rate in the world.
Bank of England – Repo rate. This is the interest rate at which the Bank of England provides short-term loans to British banks, with the collateral being securities. Banks are obligated to repurchase their assets at a certain price after a certain period.
Swiss National Bank – Libor Rate. The Swiss National Bank uses the three-month Libor rate as a tool for monetary policy. It is the midpoint of a two-percent range. It is also known as the base rate through which the SNB influences loan, savings, and mortgage interest rates.
Bank of Japan – Overnight call rate target. This is the equivalent of the American Target Fed Fund Rate. The Japanese central bank’s interest rate serves as a reference point for the average value on the short-term deposit market. To bring the interest rates on bank deposits closer to the target value, the Bank of Japan manipulates government securities.
Bank of Canada – Overnight rate target. The Bank of Canada’s overnight rate target is a benchmark for loans for banks and financial institutions. By changing this rate, the Canadian regulator influences bank loans, credit, savings, and mortgage volumes.
Reserve Bank of Australia – Official Cash rate. The RBA interest rate is the rate on interbank short-term loans, which the regulator maintains through manipulation on the government bond market.
Reserve Bank of New Zealand – Official Cash rate. The RBNZ interest rate is a tool for adjusting short-term interest rates on the financial market. The regulator accepts deposits from commercial banks at a rate 0.25% lower than the official rate and lends at a rate 0.25% higher than the official rate.
People’s Bank of China – Base interest rate. The People’s Bank of China’s base interest rate serves as a reference point for commercial banks’ basic rates. Through changes in the rate, the Chinese regulator influences all types of loans. Notably, the People’s Bank of China’s interest rate is always a multiple of 9 due to the length of the financial year.

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