interest rate: What is the essence of the interest rate in an economy?

A market rate of interest is the value given to the flow of money in the economy at a given time. It acts as a key mediator between lenders and borrowers. Basically, the interest rate is determined by the demand and supply of money, i.e. the need and availability of funds. In an efficient market, it moves in tandem with the flow of activity in the bazaar. However, in a local bazaar this could be ineffective depending on the strength of the business, the seasonal nature, the risk of the individual, the size of the funding and the availability of lenders and borrowers.

The configuration of the interest rate in a country is decided by the central banks. In India, it is based on the repo rate, which is the repurchase rate provided by RBI to banks when buying government securities, short-term. This rate depends on aspects such as the state of the national economy, global monetary policy, inflation and the liquidity situation. Based on the repo rate, the next set of rates is determined, such as the bank rate and the MCLR. The discount rate is the lending rate charged by central banks to banks, while the MCLR (marginal cost of lending rate) is the minimum lending rate that banks should charge customers.

India’s current repo rate is 5.4%, while the bank rate is at a small premium of 5.65%. The MCLR varies depending on the cost structure of the banks. RBI’s MCLR (overnight) rate, the lending rate between two banks, is 6.7% to 7.5%.

Here we can get the impression that RBI controls the financial and interest rates of India. Otherwise, it serves as the intellectual intermediary of a growing democratic economy. RBI must balance the mood of the global financial market, the position of the national economy, the management of the financial needs of the government and the strength of the INR. The monetary strength of a country depends on the effectiveness of a central bank, otherwise it has a disastrous impact on the country’s outlook, currency, inflation and interest rates.

Assuming the world is in an equilibrium state, generally, the higher a country’s interest rate, the stronger the economy and currency will be due to large money flow. However, the world is made up of markets in balance between developing countries, emerging countries and developed countries. Bubbles of geopolitical, climatic, economic and domestic risks in the financial markets. The risk of the world and the country is constantly changing, determining the strength of the economy and the currency. Therefore, the higher the risk, the higher the interest rate will be and vice versa.

Generally, the risk on a daily basis is the deviation of the parameter factor or the measure of the standard deviation over a period. The higher the variation, the higher the risk. Qualitatively, it will depend on macroeconomic factors such as the size and strength of the economy, growth, socio-political scenario and monetary policies. A country’s interest rate cycle moves on a negative slope (downtrend) as the economy strengthens.

Taking the example of a developed market like the United States, the yield on 10-year Treasury bonds peaked in 1980 at 16%, then fell to around 6% in 2000 and 2.7% today. . This is facilitated by the fact that the United States is the strongest economy and the USD is the world’s inverted currency. Similarly, we can expect a similar long-term trend for India’s interest rate cycle if the economy strengthens going forward. In the short term, it will be volatile depending on local and global factors.

(Vinod Nair is Head of Research at Geojit Financial Services.)