In the previous post, we looked into what interest rates are and what they meant for you. In this post, we’ll zoom out and look at the bigger picture.

No matter how small or big, whether it be your local hair saloon or the one and only behemoth of a tech company that is Apple, all companies carry some form of debt. And as we know already, with debt comes interest.

And as we determined in the last post, the interest rate on the debt is associated with the risk profile of the borrower. If a company needs a rescue loan to save itself from bankruptcy, the cost of borrowing (the interest) will typically be much higher than if it was a business that was making money.

This is everything that we know so far, but what if there was another force just as big, if not bigger at play here. If you own a mortgage, you’ve certainly felt the impact of this recently.

Whether you’re based in the US, UK or almost any other country in the world, your central bank is able to set interest rates for deposits held in its accounts, held by banks and other large financial institutions. Central bank deposits are basically risk free, since they have the power to issue new currency themselves. This effectively acts as a ‘base rate’ for banks and financial institutions when lending out money.

Interest rates for you, me and every borrower out there? They’ll always be higher than the base rate – this is because everyone else can technically default on their loans, so we have to pay more for lenders take on that risk.

Depending on the economic conditions of the country, the central bank will change the interest rate, which changes the cost of borrowing everywhere. If the Bank of England increases interest rates by 2%, you can expect mortgage rates to go up by 2% as well.

As determined in the post ‘how debt drives economic growth’, much of economic growth is driven by debt. A company that opens new factory or warehouse will use debt to finance purchases of property, equipment, and hire thousands of new workers. Construction companies need to borrow from banks to purchase land, materials and labour to build houses. To buy one of those houses? That’s right, you need a mortgage which is another form of debt!

When interest rates go up, borrowing becomes more expensive and when that happens, people and institutions start asking themselves: is it worth borrowing money like we did before?

The answer is no. What happens next isn’t exactly rocket science – borrowing decreases and with it, spending. Less warehouses, factories and houses are built. Fewer jobs get added to the job market, fewer cars are sold on finance.

Central banks increase interest rates to cool down economic activity .

It’s partly why job markets across the world, particularly in the UK, have been so tough – the Bank of England base rate was 52x higher in mid 2023 than it was at the end of 2021. Fewer houses were built as higher interest rates made the financing new builds far more expensive, worsening the already undersupplied housing market.

The opposite can be true as well. Lower interest rates increase demand for borrowing, resulting in more loans being taken out by people, businesses and institutions, which fosters a booming economy – more houses get built, spending on infrastructure (such as 5G, railway lines) increases and more cars are bought (especially on finance). As companies invest more, jobs are also added to the market.

So great, just keep interest rates low and the let the economy grow. No one will be jobless, we’ll all get rich from unstoppable economic growth and we’ll live happily ever after. Job done.

…if only it were that simple.

The truth is, is that there’s another force at play – introducing interest’s younger brother: Inflation. You’ve probably heard of this term before.

Inflation, like a younger brother, when taken care of properly can do a lot of good. He can create good times for people. It will grow economies into behemoths, without causing much trouble – take a look at the US for example, there’s no economy in history that has done as well. But once again, like a younger brother, if let loose he can lay waste, but not just your household; we’re talking entire communities, no matter how well everything else is going.

In the next post, we’ll be exploring inflation and its relationship with interest rates, and how it can change the lives of people like you and I.