An entire generation of people is about to experience higher interest rates for the first time in their adult lives.
Interest rates have been at historic lows since the global financial crisis – but
they’re beginning to creep up.
If you look at what’s happening around us today, we seem to have a situation that,
I think, matches more what we saw 50 years ago.
But what is an interest rate anyway, and what will this change mean for your life?
Most people borrow money at some point in their lives – whether it’s to buy a house,
a car, for education, or to start a business.
But with interest rates on the rise, that’s about to become a lot more expensive.
Here’s why.
Let’s say you want to buy a car, but you’re short $20,000.
An option a lot of people take is getting a loan from a lender like a bank or credit union.
In this example, a bank has agreed to loan you the $20,000 for your car.
But the bank isn’t going to give you that money for free.
After all, there’s a chance you could not pay them back – or that the $20,000 will
be worth less in the future because of inflation.
So, you compensate the bank for the money.
'Interest’ is what you're charged for the loan, usually represented by a percentage
of the total amount borrowed. The higher the interest rate, the more you owe the bank.
This is one of the main ways lenders make money.
So, who decides whether interest rates are up or down? The answer is your local central bank.
At a very basic level, the interest you pay the bank usually depends on a few things:
How likely it is that you will pay the debt,
how long it takes for you to repay the money and
your central bank’s interest rates, and where they may head in the future.
You see, a central bank is a bank for banks.
If it raises interest rates, it makes it more expensive for your bank to borrow money.
If the central bank lowers rates, it's the opposite.
And that works its way out to the economy - and to you and your car loan.
Central banks such as the U.S. Federal Reserve and the Bank of England use interest rates
to try to manage the economy.
And for the first time in more than three years, both central banks raised their interest rates.
A number of countries have also raised their interest rates in the last six months, including
South Korea, India, New Zealand and Brazil.
But why?
As the pandemic devastated markets and slowed economic growth, many central banks made aggressive interest rate cuts.
This lowered the cost of taking loans, which in turn spurred consumer spending and encouraged big credit purchases.
Now, with demand recovering and supply chains affected by the pandemic and the Ukraine war, inflation has gone up.
This time round, we got this perfect storm of both supply disruption and rising wealth
that is creating this very bad inflationary situation.
Lee Boon Keng worked in the finance industry for 15 years and is now a banking and finance professor in Singapore.
Inflation is caused by what we call excess demand, whether your excess demand is caused
by falling supply or rising demand, it’s still excess demand.
A lot of people were thinking the pandemic will be more damaging, economically.
The fact that there were a lot of government injections into the economy, has somewhat
lifted everyone, and that creates what I call wealth effect. We got geopolitical crisis.
We got China, which is literally the manufacturers of the world, deciding that they need to have
zero-Covid, and therefore it’s shutting down.
So, this is a very bad concoction.
Rightfully, policymakers should be acting in a way to tame inflation.
And the main tool central banks have is interest rates.
Raising interest rates has historically slowed economic growth and reduced inflation.
High interest rate was somewhat transitory in the past.
They somehow managed to tame it quite easily, and that is a phenomenon that we've seen easily
for the last 35 years.
Unfortunately, this time, what we're seeing is a period where inflation seems to be a
little bit more structural.
We’ve gone into a time where we sit back, look back in history and couldn’t find a
time that is familiar to us, that we can relate to, and I think that’s the fundamental problem.
And that – what I call – policy hesitancy has kind of caught the entire system by surprise.
A lot of policymakers have been hesitant to react more structurally, more aggressively
to the current situation.
What would be the adverse impact on the average consumer who is experiencing high interest rates right now?
You want to buy your big-ticket items, those are going to be more expensive.
If you were borrowing money to run your business by borrowing cost, it’s also going to be on the rise.
It’s not a situation for you to really go all out in terms of ramping up your loans and all these things
so that you can take advantage of rising real estate prices and all these things.
It’s really about investing within what you’re comfortable at.
But it’s not all bad news.
Higher interest rates can be good for your savings.
Banks incentivize customers to save their money with them by offering to pay you interest.
It seems like a good deal.
You make money for parking your cash in a savings account.
But generally, the earnings from these accounts for the last decade and a half have been minimal.
And many people are choosing to put their extra money in riskier places –
like investing in stocks or crypto – instead.
This shift in policy could change that.
So I started working about 10-ish years ago, and interest rates have always been really low since then.
Millennials are in our life stage where we are spending on really the big-ticket items in our lives.
Dinesh Dayani is the co-founder of Dollars & Sense, a personal finance portal based in Singapore.
You can continue investing, continue putting the bulk of your investments into maybe fixed
deposits, maybe hopefully, with rising interest rates, they rise a little bit as well.
So, you can eat back a little bit on inflation.
But I don't think it's going to be easy for someone who is retiring today and need a very
safe basket of investments on their portfolio.
So, if you want to invest, invest through low-cost brokerages.
And then I mention credit cards.
We don't really get cashback for credit cards.
But you know when we sign up for credit cards, we tend to get a lot of perks as well.
So we can spend a bit smarter as well.
Recently I even actually signed up for this BNPL option.
BNPL stands for ‘Buy Now, Pay Later’ and it’s an increasingly popular payment method
for consumers to purchase an item and pay for it in future installments, usually without interest.
I was literally at the store already buying something and then the store cashier or owner
told me that hey, if you sign up for this, you get instantly 20% off.
Like, 30% off. Exactly.
I think we have to be prudent here because on one hand we can spend more than we realize
by using some of these options.
But if we're spending prudently and using this to offset only the cost that we're already
going to incur, that's another way that we can lower expenses for ourselves.
We are in the repeat of the 70s where inflation is going to be persistently high at least for the next two years.
We have to brace ourselves for a recession.
Diversify. Look at your finances.
Make sure that you’re not overextended.
My recommendation to a lot of people right now, make sure you hold your job.
Your job is very important to combat inflation.
There is this thing called the Great Resignation that’s going on.
A lot of people think that look, I go out there, if I quit my job today, I find another
job with X percentage increase in pay.
But once a certain tipping point happens, you will be what we call ‘last in, first out’.
Inflation is just a good excuse slash chance to relook the non-discretionary basket and
rethink what we're spending on.
There is no other way to end this inflation, given that supply chain disruption in the
background, besides demand destruction, and demand destruction can only be achieved by
very, very tight monetary policy.
And that includes high interest rates.
Yes, and that includes high interest rate, very high interest rate.