Why do interest rates matter?

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As the world issues warnings of a rising rate environment, we try to set some context and explain what it means and why it matters.

For most of the past decade, homeowners may have been delighted by lower mortgage repayments, while equally disappointed by paltry gains on any savings. The interest rate is the cost of borrowing; set by central banks, known as the base rate (or the rate at which banks lend to one another) and at individual level, meaning the cost of loan or credit cards repayments, for example. Think about it: if interest rates are low, people are far more likely to consider a loan for a car or other ‘big ticket’ item, or take out a new credit card to buy more stuff. They will certainly be reluctant to park any savings in the bank as the level of interest will be hardly worthwhile. The same rules apply to the corporate world. If industry and companies can borrow at lower rates, they may be more inclined to invest in new machinery or expand their sites if leases are comparatively low, for instance. The idea is that spending fuels the economy. And, having been at just-above-zero interest rates for almost 10 years now, people are getting twitchy as they see consecutive interest rate hikes around the world. As economic recovery gains pace, central bankers become concerned over inflation risk. Generally speaking, higher inflation is unsettling for governments, business and households. One way to control that inflation is to increase interest rates. In a global world, if domestic costs look relatively high, manufacturers have to look further afield to manage their supply chain, for example, which opens up discussions about currency and overseas taxes. And they matter; for all the same reasons, in reverse. If interest rates go up, we all have to spend more to service our debts. People don’t head out to the shops so much. Companies spend more on their loan repayments so have less spare capital to spend on product development and wage increases. Productivity slows, people may be laid off work as orders shrink, and anyone with any loans to replay will find it harder to do so. On the plus side? Bondholders and savers can look forward to higher yields, finally. But at the expense of shareholders. Clearly a well-planned, diversified investment portfolio has never been more necessary.

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