- Feb 17, 2018
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The impact of interest rates on law firms - Part 1
Hey guys,
This is a very popular interview question this year so I’ve decided to do a mini-guide. I know I’ve briefly touched on these areas in other posts, but hopefully, this’ll help you to connect the dots further. I hope to release part 2 tomorrow.
Who raises interest rates?
That’s the central bank. Almost every country in the world has one. I’ll focus on two – the Bank of England in the UK and the Federal Reserve in the US. Right now, when you see the press talking about the ‘Fed’, that’s short for the Federal Reserve.
How do central banks raise interest rates?
Central banks don’t actually control the interest rate. They influence it. They do this by deciding how much money there should be in the economy. The amount of money in circulation at a given time is called the money supply. If the money supply increases, it can stimulate lending and growth, but it can also cause inflation to rise – we’ll get to that below.
If central banks want to raise the interest rate, they will reduce the money supply. There are a few ways they can do this. One way is to increase the discount rate (the base rate in the UK). The discount rate is the interest rate at which a bank can borrow from the central bank if they want a loan. If the central bank raises the discount rate, the banks tend to respond by raising the interest rates on their loans.
What’s inflation got to do with this?
In 1971, a packet of crisps cost 5p, a cinema ticket cost 30p and a house less than £6000. Why is everything more expensive? You can (generally) thank inflation for that. Inflation is where the price of goods and services rise over time.
What causes inflation?
Inflation can be caused by rising business costs. If the cost of raw materials rise, a business may increase their prices to maintain their profit margins. The central bank can also cause inflation if it prints too much money relative to the productivity in the economy. When there’s more money chasing a limited amount of goods and services, the excessive demand can push prices up.
That’s what happened to Venezuela. A quick background – Venezuela’s economy is almost entirely dependent on exporting oil. So when oil prices crashed in 2014, the government couldn’t fund its expenses. Instead of cutting its social programmes or seeking help, the government decided to print money. The thing is you can’t just print money because the value of the currency will fall. Which it did, a lot. This was a problem, not least because the country relies on imports for most of its food, which it pays for in US dollars. But even as the currency fell, the government continued to print money. To give you an idea of how bad things have become - the International Monetary Fund predicted inflation will reach 13,000 by the end of 2018.
Why do we have inflation?
You might have seen that the Bank of England and the Fed targets an inflation rate of 2%. A low and stable rate of inflation isn’t necessarily a bad thing. It causes people to spend or invest because if they don’t, their money will be worth less in the future. The central banks can also control inflation if it rises too quickly.
The opposite is true if inflation falls below zero. That’s deflation. It’s where prices fall over time. Deflation causes people to spend and invest less, because their money is worth more tomorrow than it is today. If people stop spending, prices fall even more, causing a deflationary spiral.
You can look into Japan for a recent example of this. They’ve been battling with deflation for almost 20 years. When prices start to fall, it’s hard for the central bank to fix it using interest rates. Japan did try - they introduced negative interest rates in 2016, which penalises banks for holding cash. The country also printed money on a massive scale (also known as quantitative easing). That may have worked – it’s hard to say, but the economy is almost out of deflation for good. Unfortunately, Japan also has the highest debt-to-GDP ratio in the world.
How do interest rates impact exchange rates?
Suppose the interest rate in the UK and the US is 2%. Fast forward a few months, let’s imagine the Fed raises the interest rate to 3%. Now investors can get a higher rate of return by investing in US government bonds. So, all things being equal, investors sell sterling so they can buy dollars. As there’s high demand for the dollar, its value increases.
So what?
The short answer is that it’s good for imports, bad for exports.
The longer answer: when the value of the dollar goes up, it’s cheaper for people in the US to buy goods abroad, so imports tend to rise. That’s good for US companies who import products or raw materials from overseas. It can also help foreign companies. For example, if a UK company does business in the US and generates income in dollars, its earnings will increase when it’s converted into dollars. This could lead to more foreign companies investing in the US.
But a stronger dollar affects companies which export US goods. They tend to see a fall in sales because their goods become more expensive. US multinationals with overseas businesses are also hit. A stronger dollar means companies will record lower income in its books when it’s translated into dollars.
What about the stock market?
It tends to fall. Investors worry interest rates are going to increase. If interest rates increase, it can be more expensive to borrow, which can slow down a company’s growth. Likewise, if interest rates increase, bonds become more attractive because investors will get a better return (more interest payments). So many investors sell shares to invest in bonds.
There’s also a few other reasons. Janet Yellen just left as the chairman of the Fed and her replacement, Jerome Powell was only recently sworn in. A new chairman causes uncertainty for investors, especially when the central bank has been lenient with low interest rates for so long. He’s also the first non-economist in almost 40 years.
Why are they raising interest rates this time?
First, it’s important to remember that interest rates have been really low for a long time. This was in order to stimulate growth after the financial crash.
Now the US and the UK are more than eight years into their recovery. The US economy is doing well. It’s seen wage growth and low unemployment rates. When the economy is growing and wages are growing, the Fed thinks the economy can take the rise in interest rates.
Why are people worried?
There are fears that the US economy can’t sustain an increase in interest rates. Some say it isn’t growing fast enough. Others point to the number of companies with lots of debt. Investors don’t like uncertainty either. There was a sell-off in the bond market as investors fear being locked into fixed returns.
The UK tends to follow the US in raising interest rates. This was also supported by unemployment falling to a 42 year low in December 2017. However, we’ve got Brexit to deal with, so it makes less sense to do so when the markets are already troubled.
Then there are the emerging markets. When the Fed lowered interest rates in 2008, it became cheaper to borrow in dollars and many emerging markets took out loans to build new infrastructure and expand their economies. Borrowers in emerging markets will be hurt because they have plenty of dollar-denominated debt. If interest rates rise, investors are also likely to flock to the US and sell emerging market currencies. So these markets tend to rattle at signs of a rise in interest rates.
Part 2 to follow!
