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Do you truly understand interest rates?

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By Simon Danaher - January 20, 2016

Do you understand interest rates[Estimated time to read: 4 minutes]

Rising interest rates have the potential to snuff out growth and stifle investment returns.

Successful investors should be aware of the potential impact higher interest rates can have.

But is there cause to worry?

Why interest rates matter

Interest rates – particularly in the developed world – have been kept low by central banks for what’s probably an unprecedented amount of time.

You may be wondering why low rates matter.

In the years following the 2008 global financial crisis and the subsequent recession, central banks in the US, the UK, Europe and Japan attempted to encourage growth.

There were two things they did – one was to decrease interest rates and the other was to implement various programmes of ‘quantitative easing’.

Decreasing interest rates boosts spending because borrowing money becomes less expensive. Simply put, cheaper money encourages consumers and corporates to spend.

It also impacts cash savers adversely, though, because the return they get on their money decreases. This has the arguably positive effect of encouraging investment in more risky (but potentially more rewarding) assets such as bonds, equities and property.

The combined effect of low interest rates, therefore, is positive for the economy and for stock markets.

With borrowing less expensive, house prices can often also rise. Combined with low borrowing rates, this can create a feeling of heightened wealth among homeowners, which again can often lead to increased spending and economic growth.

Until the end of last year, the US central bank – the Federal Reserve – had not increased interest rates since 2006 (having decreased them to near zero in 2009). This has meant the impact of cheap money has been felt all over the globe.

It is important to point out here that many countries – especially emerging economies – have their currencies “pegged” to the US dollar.

What’s the downside of cheap money?

In addition to being bad for cash savers, low interest rates can cause other economic headaches.

Boosting the value of “risk assets” and property feels good in the short term; if this is prolonged, it can create bubbles which will eventually burst and can send economies back into recession.

The London property market is a prime example of where favourable economics (as well as, until recently, favourable tax laws) has meant prices have risen dramatically.

Prices have risen to the point that some are calling it a bubble and warning of a crash.

The UK government will be watching London closely and has already introduced measures to make it less attractive to overseas and buy-to-let investors.

Rising house prices are also detrimental to first time buyers and those who rent.

Another long term risk of keeping interest rates low is the negative signal this sends to consumers and stock markets.

While low rates are undoubtedly good for growth in the short term, if a central bank continues to put off increasing rates, it can raise questions over the bank’s confidence in the economy.

What’s next for interest rates?

As mentioned, in late 2015, for the first time since 2006, the US Federal Reserve increased interest rates. It was only a subtle rise, but it does mark a new phase in the country’s economic policy.

It is currently widely anticipated that there will be further increases during the course of 2016. We look closely at the impact this will have here, but the main points are that the rise signals confidence in the US economy, even if it could make life harder for already embattled emerging economies.

Although the Bank of England is expected to increase rates this year, market expectations of when this might happen keep being pushed back. Asset manager Schroders recently revised its forecast for a rate rise from May to August. Others predict that rates will not move until 2017.

The European Central Bank, meanwhile, only recently extended its relatively new programme of quantitative easing, so seems unlikely to raise rates until late 2017 at least.

Japan, the world’s third largest economy, also looks likely to keep interest rates low, which in turn will maintain downward pressure on the yen and support exports. China is also expected to cut interest rates to give a similar boost to its slightly lagging economy.

Since 2008, central banks have been at pains to ensure any rate changes are clearly flagged to markets so as to prevent shocks. The only place where this hasn’t happened is in China and even the People’s Bank of China may have learnt a lesson after Black Monday last year.

When rates rise there may be some adverse impacts on stock markets. However, many commentators now agree that increases will be gradual and clearly flagged and should avoid creating significant shocks.