Kondi Nkosi – Country Head, Schroders in South Africa
Interest rates have been rising all over the world.
In the US, the Federal Reserve (Fed) has raised rates twice this year already – by a quarter of a percentage point in March and by half a percentage point in May. They’re now at 0.75%-1% in the US and 1% in the UK after the Bank of England, the UK’s central bank, increased rates four times since December 2021.
Interest rates are also at 1% in Canada, where the central bank has raised rates twice this year, while in Australia rates have been increased to 0.35%. They’ve also been raised in many emerging markets including India, Mexico and South Africa. Locally, South Africa’s interest rate is at its highest level in five years – on 21 July, the South African Reserve Bank (SARB) announced that interest rates would increase by 75 basis points (bps), taking the repo rate to 5.5% and the prime lending rate to 9%.
It’s anticipated that rates will continue to rise. Our economists at Schroders predict that rates in the US will reach 3% by the end of the year and that in the UK they’ll hit 2.25% sometime in the first quarter of 2023.
What are interest rates?
Interest rates represent the cost of borrowing.
When a central bank, such as the South African Reserve Bank, Bank of England, US Federal Reserve or the European Central Bank announces a new rate, this determines the cost to local banks when they borrow. In turn this steers the rate at which banks lend to each other, and it also influences the interest rate at which they will lend to the consumer (that’s you).
So when the bank rate goes up you would expect your mortgage rate to go up too, and vice versa. (Of course, other factors are involved in setting mortgage rates, including the stability of your income.)
Why are interest rates rising?
Central banks are currently raising interest rates in order to contain inflation (an increase in prices and a fall in the purchasing power of money). Most central banks have an inflation target or an inflation target band.
For example, the Bank of England’s and the European Central Bank’s inflation target is 2% while the Fed targets an average inflation of 2% over the long term. In both economies, current annual inflation is at close to 40-year highs at 9% in the UK and 8.5% in the US and 7.5% in the eurozone (as of April 2022).
In South Africa, the Reserve Bank’s target band is 3%-6%. Current annual inflation is over 7% (as of June 2022).
Central banks try to influence spending habits when they change interest rates. Interest rates influence the overall level of activity in the economy.
If interest rates are higher we’re more likely to save, because we’ll earn more interest on our savings. Borrowing is also more costly. This reduces spending within the economy, which tends to dampen inflation.
Importantly, higher interest rates won’t have an immediate impact – it takes time for their effects to filter through the economy.
Savings, loans, credit cards and store credit: what will higher interest rates mean?
Generally a rise in interest rates is good for savers (you’ll earn more interest on your savings) and bad for borrowers (you’ll have to pay more on your loan).
As interest rates rise, you would expect to pay more for mortgages, loans, credit cards and store credit. Lenders are normally quick to pass on rate increases to borrowing customers. Some loan agreements – including certain mortgages and credit card deals – have rates which are fixed for a set period. But they usually revert to a variable rate at the end of that term, so check the details of any credit agreements.
Although you’ll be seeing many headlines about higher inflation and rising rates, the fact is that interest rates in most countries remain very low compared to their long-term averages.
What does this mean for my investments?
The good news is that if you have a well-diversified investment portfolio some of the assets you are invested in may benefit from higher interest rates – such as cash. Conversely, you may see a drop in assets like bonds. Although we are experiencing extremes in the market, the basic pillars of good investment still exist such as remaining calm and avoiding rash decisions, staying invested and speaking to a professional financial adviser about potential changes to your portfolio.