Central Bank Interest Rates

Why is it important?

These are the interest rates levied by the government on any moneys borrowed from the Federal Reserve banks. This rates ones set by the Federal Reserve board apply to all other banks as they also have to keep their reserves with the federal bank. It therefore means that they too have to pass the same rates over to their clients in the money supply chain. These interest rates are very instrumental in determining whether to borrow money from the banks to finance economic projects. The economic growth is always driven by investments into the economy so if the investors feel that the rates are too high for them to take loans for development then the economic growth is very much likely to stagnate or even take a downturn if other investors decide to exit the country in search of better environments. Setting these rates at the right level is therefore a major driving force behind any economic changes in the country.

How is it computed?

The Federal Reserve Bank determines the interest rates after considering several economic indicators and reports. This is because the reports may be the only sure way of telling whether the country needs to introduce stimulus packages to enhance investments or whether the economy is in recess or is growing before thinking of the correct action to take. Several details but more so the balances of trade as well as the current account balances and the unemployment situation determine the federal bank’s decision regarding interest rates.

Impact on forex

There is a very direct interdependence between the forex rates and the central bank interest rates. The two influence each other depending on prevailing economic circumstances on the ground. The central bank uses the forex rate to gauge the balance of trade in goods and services internationally. If the central bank experiences a deficit in international trade balance the policy makers know that, the amount of exports have reduced significantly. This is a clear signal that investments in the production of goods for export have declined and the sector may need some incentives to increase production. Since the decline in exports reduces the country’s reserves of foreign exchange currency, the central bank may be compelled to buy foreign currency at increased interest. The federal bank will have to reduce interest rates to attract people to do business with the dollar. In the event that the country has a surplus, then it should be fairly in control and the value of the dollar will naturally be strong.

Gauging from this relationship it is clear that the two factors are quite complementary in determining economic trends. The federal bank’s major concern is to maintain the interest rates a manageable levels since most investments will depend on the rates to make crucial investment decisions. If properly managed the interest rates should be able to guard the economy against economic extremes such as inflation or deflation.

Impact on stock markets

The stock market reacts dramatically to central bank’s interest rates. These interest rates will always give the investor an insight into the expected direction of the economy. If the government maintains a high interest rate, investors will slow down on loans for new investments and the economy will slow down or stagnate. The federal bank therefore raises or lowers interest rates in a bid to influence the investment trends of the country. When interest rates are lowered, the investors know that it is time to borrow for expansion or new investments. The economy is therefore likely to get bullish as investor rush to capitalize on the incentive. If the rates go up the reverse effect takes place. The federal bank will therefore use this rate as a means of maintaining economic growth at their desired levels. It takes a shift in interest rates to shape the destiny of the country’s entire investment atmosphere. The same rates also influence the GDP thus influencing the population’s purchasing power, a trend that may again spill back to the stock market if the people decide to invest the money they earn in stocks.

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