Interest Rates - An Insight

Summary

Rajaram Ajgaonkar’s booklet, reproduced from the Bombay Chartered Accountants’ Journal (May 2016) and reissued by the Forum of Free Enterprise, offers a primer on how interest rates are set and what their movements mean for an economy. Ajgaonkar, a Chartered Accountant, begins from first principles — interest as the price of borrowed money, alternately framed as rent for a lender, cost of capital for a business, and the cost of preponing consumption for a household — and builds outward toward the macroeconomic forces that move rates.

The central analytical block surveys the major determinants of interest rates: monetary policy and the central bank’s balancing act between growth and inflation, the demand pressure exerted by the growth rate, global and local liquidity (including the way cheap money fuels and then unwinds carry trades), economic and political uncertainty, and the inflation rate itself. He then moves to transaction-level factors — type and cover of security, tenure of loan, end-use of funds, the borrower’s creditworthiness, and the industry to which the borrower belongs — that explain why a single benchmark rate fans out into very different effective rates across borrowers.

A substantial section is devoted to the post-2008 phenomenon of negative interest rates in the Euro Zone, Japan, Sweden, Denmark, and Switzerland, where central banks invert the usual logic of lending and effectively penalise banks for holding cash. Ajgaonkar enumerates seventeen distinct effects of low interest rates — on savers, senior citizens dependent on deposit income, charities, banks, consumer durables, housing, stock and bond markets, capital-versus-labour substitution, currency stability, and the temptation toward riskier assets — arguing that the welfare verdict depends on the weight one places on each constituency.

The rendered pages close with the opening of an “Indian scene” discussion in which Ajgaonkar credits supply-side reforms with bringing CPI inflation from 9.70% in 2008 down to 5.72% in 2016 and tracks the RBI’s repo rate cuts from 9% to 6.50% over the same span. He projects further gradual easing if inflation stays anchored; the chunk cuts off mid-paragraph as the comparison with developed economies begins.

Key points

• Defines interest three ways at once: rent for the lender, cost of capital for a business, and the cost of preponing consumption for a household.

• Catalogues five macro drivers of interest rates — monetary policy, growth rate, liquidity, uncertainty, and inflation — and explains the central bank’s balancing act between growth and inflation control.

• Adds a second layer of transaction-level determinants: security quality, loan tenure, end-use of funds, creditworthiness, and industry, showing why one benchmark rate produces many effective rates.

• Explains the carry-trade mechanics that link low domestic rates to capital flows, and how a reversal of those flows can unwind carry positions and pressure currencies.

• Analyses negative interest rate policies in the Euro Zone, Japan, Sweden, Denmark, and Switzerland as a post-2008 dislocation that inverts the lender-borrower payment relationship.

• Enumerates seventeen effects of low interest rates — punishing savers, senior citizens, and charities; aiding entrepreneurs, housing, and stock markets; risking asset bubbles, capital-for-labour substitution, and bad-loan build-up.

• Tracks the Indian disinflation: CPI from 9.70% (2008) to 5.72% (2016) and RBI repo rate cuts from 9% to 6.50%, attributing the improvement to supply-side strengthening.

• Frames the welfare verdict on low rates as a weighting problem between business/borrower gains and the erosion of nominal incomes and real living standards for savers.