One of the most closely-watched economic indicators is the interest rate. In Singapore, the overnight lending rate between depository institutions is the Singapore Interbank Offered Rate (SIBOR). In the U.S., the benchmark interest rate for financial markets is known as the federal funds rate, which is the rate at which banks charge one another for overnight borrowing. It is not an exaggeration to say that interest rates are of primary concern to all economic participants.
If you are the Chairperson of the Federal Reserve, your decisions on the interest rates will affect everyone. So, how does the Federal Reserve set interest rates?
Let’s Get on a Train
Imagine you are driving a train through undulating terrain on a very long journey. There are many ups and downs, and your aim is to keep the speed of the train constant so that your passengers don’t feel nauseated. There is only a lever which speeds up the train when it is down and engages the brakes when it is up. So, what does a good train driver need to do? When you go uphill, you need press the accelerator down. When you go down a slope, you will need to let gravity chip in and maybe engage the brakes.
If your passengers are bantering about the weather or complaining about life’s little nuisances, and no one notices all the hard work you are constantly putting in, then congratulations! You are a terrific train master. However, if your passengers are vomiting out the windows and onto the floor, then you know you’re a terrible driver.
In this imaginary scenario, the train is a metaphor for the economy. The speed of the train is inflation. If the economy is struggling, it would be like the train going uphill. Lowering the key interest rate is like pulling down on the accelerator lever to speed up in the hope to keep the speed (inflation) constant.
On the other hand, if the economy is experiencing optimism and robust growth, this is like going down a slope. It will be wise to raise interest rates and put the brakes on the irrational exuberance. The Chairperson of the Federal Reserve can be thought of as a train driver, and the best train drivers will do their best to anticipate the terrain ahead, especially at night or in heavy rain when visibility is poor.
Whenever a financial crisis hits, it is like coming up against a sudden upward slope in the dark of the night. In response, the central banks around the world will pull down the lever – lowering the key interest rate. This should counteract the slowdown in the economy, and hopefully, the passengers (you and I and our families and friends) will have a smoother ride. Simplistically speaking, when prime and mortgage interest rates are lower, businesses tend to borrow more, and more people can afford to buy property, thereby propping up the economy.
The Cumulative Effects on the Economy
The fact is, changes in rates directly impact almost all economic and financial activities such as mortgage and loan payments, investment returns, foreign exchange rates, asset values, and GDP growth. How this works is that when the federal funds rates change, other interest rates will most likely change in tandem almost immediately. If the federal funds rates are lowered, the prevailing mortgage rates will likely dip too.
This is but one of many ripple effects exemplifying how interest rate changes by the Federal Reserve in the USA can affect nearly everyone in the world. In Singapore, our central bank, the Monetary Authority of Singapore (MAS) does not manipulate interest rates directly but do so through the careful and prudent management of the currency exchange rates against the country’s major trading partners.
The subprime financial crisis of 2008 is thought by many to be the worst financial crisis since the Great Depression of the 1930s. If you were driving the train during the last great recession, you can imagine the crisis as the train suddenly having to climb a super steep slope. All good central banks lowered their interest rates to nearly zero; which means the accelerator lever is all the way down.
However, even full speed is not fast enough against such a steep incline. The train was at real risk of slowing down (disinflation) or even going into reverse (deflation). Hence there were many furrowed eyebrows and much worrying by all the train drivers, while all the passengers were feeling nauseated.
With this toy train model, we hope you have developed an intuition on the issues at hand that are plaguing the Federal Reserve. It has been nearly ten years since the crisis of 2008, and all this time, interest rates have been set at a low level. If the economy is still bad (i.e. we are still climbing uphill), then yes, interest rates should be kept low.
However, if we are chugging along on flat terrain, or worse, if we are on a downward slope, then you will soon realize that low-interest rates are a recipe for disaster, and the train driver should be urged to start braking quickly!
How the crisis was averted is an exciting tale for another time. Nevertheless, I hope you will never again confuse inflation and interest rates and their interactions with the economy when you come across such terms henceforth in the fake and real news outlets.
Dr Jonathan Khoo is a founding partner of Research Room Pte. Ltd., an advanced analytics consultancy. Dr Khoo graduated with double first-class honours in Economics and Electrical Engineering, followed by a master’s degree in Industrial and Operations Engineering, then a doctorate in Finance. He started his career at the Ministry of Trade and Industry as a government scholar. Today, he is a full-stack data scientist. Having published on genetic programming while working towards his undergraduate university degree, his current endeavours is focused on expanding the capabilities of Artificial Intelligence in the realms of developing prescriptive actionable insights for commercial, government, and not-for-profit organizations. He was a Board Member of the National Arthritis Foundation, a local charity, and he currently volunteers his spare time on the Certification Board of the Financial Planning Association of Singapore.