What are "Interest Rates" that central banks announce.

Can someone explain to me in a short-summary in english why these exist and definition of it? I just know that if the interest rate for that currency is from 2.5% to 4% then it would be strong for that currency over the long-term....

OK...I'm not an expert on this, so please...take every word I say with a little skeptism and do a little research yourself.

From what I understand these rates are actually the short-term interest rates. Thus, if someone borrows money from the treasury, that is the interest that they will have to pay. Mind you...only large banks can deal with the central banks...so technically, what's happening is that when you (specifically) have to borrow money on a short term basis, you're actually getting a markup on the note the bank has already bought.

you're guage of 2.5%-4% is purely arbitrary.

Think of it this way. When you take out a loan, do you want your interest rate to be higher or lower? You want it lower, because you won't have to PAY as much interest on the loan. The lower the interest rate, the more investment in the country's currency you generate because companies will be more willing to invest in the country because loan rates will be much better.

However, as growth is spurred, jobs are created and people in that country become more prospersous and willing to spend. Once they start spending, demand for certain materials and goods start to rise. As these core materials start rising in price, companies start slowing in growth. Earnings drop, and company investors take it out on the stock price which can force less spending and lay-offs. Which hurts growth and prosperity.

On the flip side...a higher interest rate also spurs investment in the currency itself because that's how much the government will PAY YOU to hold onto their currency. However, as this occurs, the price of the currency inflates...which causes exports of a country to become much more expensive than comparable exports from other countries. This also hurts growth for multinational corporations. So, it's a bit of a balancing act. A country wants the currency rates to be low enough to attract investments to spur economic growth, but high enough to encourage currency investment without hurting foreign investments.

Then, of course, you have the politics part of this...which is just as complicated.

So...yeah, thought I could give you this in english...LOL...I guess I can't really.

This is also my opinion and I am not an economist....

The interest rate we see announced by the big central banks is the what called one night interest rate...Central Banks calculate the interest payment for loans on a per day basis...Thus, if the one night interest rates for the USD for example stands at 5%, then a $100 M loan will have to pay a $5 M yearly interest and thus it will cost $13,698.63 in interest every day, that's how it is calculated....

Banks borrow money from central banks at this rate and then re-lend it at a slightly higher rate and pocket in the difference...


Thanks,

Nader

The central banks do set an overnight rate, which the markets are deeply concerned about. In the US, this is the Fed Funds Rate. Narafa's calculations are correct, but the usage by the banks and the reason for its importance are incorrect.


I live in the US and am most familiar with US banking, so I will use them for examples...


Banks are required by the central bank to maintain a percentage of deposits in reserves. These reserves are used for daily withdrawals by the banks patrons. The central bank mandates specific levels of reserve because if at any point an individual attempted to claim his deposits and could not get them, a banking crisis would emerge.


A bank makes a large number of transactions in a day, and they like to keep as much of their money active as possible. Occasionally a patron will wish to make a large, unexpected transfer of funds out of his bank. This will cause the bank to fall below the reserve requirement set by the central bank, which will land them in a whole heap of trouble. The Fed Funds Rate is the rate that the bank would have to borrow money at to comply with the reserve requirement. Usually they borrow it from another bank that has more money in reserve then necessary. If there are no such banks, the central bank will provide the loan.


However, this loan must be paid off the next day. The Central bank does not look warmly on a bank that is constantly borrowing money in such a manner, and will raise the banks reserve requirements. Saying the central bank just loans out money to banks for lending purposes leads to all sorts of misconceptions about banking and undermines the integrity of the banking system itself. It is for this reason I feel you need so much detail...


Anyway, the reason this interest rate is important to the markets is that ALL the other interest rates charged in a country are derived from this rate. The Fed Funds loans to member banks are the lowest risk loans that can exist. They are overnight loans to financial institutions with perfect credit ratings. From this risk free rate, term, credit, and other risk premiums are added depending on what type of loan is being sought.


That's what it is. The question of why it's important depends on what type of security you’re looking at. For stocks higher interest rates are bad because it raises a companies cost of capital. For bonds it's good because it reduces the risk of inflation.


Forex is a bit more complicated in that interest rates affect a currencies relative value on several levels. There is of course the swap rate that is charged/paid for borrowing/holding a currency. But this is only a small portion of the equation. International portfolio flows (which account for a vast majority of the forex volume) are investors in search of better yields on their capital. Depending on what a countries stock, bond, and real estate markets (as well as its inflation rate) look like, an interest rate increase could be seen as good or bad for the underlying investments. For a more detailed understanding of how interest rates actually affect a currency, you should look into John Percival's The Way of The Dollar. I think there is a link floating around here somewhere...


Probably more then you ever wanted to know.


PS- mrmikal - The treasury doesn't make loans. Ever. Period. This is the source of all sorts of other misconceptions...