There are four most important factors that influence interest rates and the shape of yield curve.
- CBK – Monetary policy
- The level of government budget deficit
- Balance of trade position
- Business activity (circle) in the economy
1. CBK – Monetary Policy
The money supply in the economy has a major effect on both the level of economic activity and the rate of inflation. The level of money supply is controlled the CBK.
If the CBK wants to stimulate the economy, it increases the money supply. The initial effect of such an action is to cause interest rates to decline but this may also lead to increase in expected rate of inflation which in turn pushes the interest rates up in the long run. The reverse of this would happen if the CBK tightens the money supply in the economy.
During periods when CBK is directly interfering with the market, the yield curve will be distorted. S.T interests will be too high if the banks are tightening their credit and they could be too low if the banks are easing the credit.
2. Government Budget Deficit
If the Government spends more than it takes in from tax revenue, it runs a budget deficit. This deficit must be covered or financed either borrowing or printing more money. The Kenya Government has in the past used the two ways of financing its deficit in a balanced manner. The effect in interest rates is whether the deficit is financed through printing or borrowing. The Government would borrow in the S.T market which increase the demand of available funds for lending which subsequently pushes the interest rates up.
If the Government prints more money this will lead to inflation and the interest rate would eventually rise.
Therefore the larger the Government deficit, the higher the level of interest rates.
3. Foreign Trade Balance
If the Government buys (imports) more than it sells (exports) there will be a trade deficit which will require financing. The main source of financing could be debt. This Government would once again go into the market and borrow and cause an upward pressure on funds available for lending.
This causes the interest rates to go up. If there was a favourable balance of trade the Government could not borrow and the interest rates could remain relatively stable.
4. Business activity cycle
The interest rates also depends on business cycles (as above). As the economy moves in the four (4) business cycles, interest rates will shift as well e.g during economic recessions, short-term interest rates experience sharp decline than L.T interest rates. This is because of the following reasons:
- The CBK operates mainly in the S.T Sector (market) and its intervention has a major effect on S.T interest rates.
- L.T interest rates generally reflect the average expected inflation rate over the next 10 – 20 years.
These expectations do not change generally because L.T interest rates are fixed due to debt covenants entered into during borrowing time.
Other Determinants of Market Interest Rates (Required Rate of Return)
5. Risk free rate – This is the interest rate that would exist on default free securities such as Treasury bills and bonds.
Risk free rate is made up of two components:
- Real rate of return – interest rate if there was no inflation
- Inflation premium
Therefore risk free rate (RF) = Real rate of return + Inflation premium.
If risk premium is added to risk free rate, required rate of return is derived. Therefore required rate of return = real rate + inflation + premium + risk premium = Risk free rate + Risk premium.
6. Inflation premium – Investors are compensated for reduction in purchasing power of money. From point (1) the higher the inflation premium, the higher the market interest rate.
7. Default risk premium (DRP)
This is the rate added to risk free rate for possibility of default in payment of loans. Usually, its added if two securities have equal maturity and marketability.
8. Liquidity premium – This is premium added to equilibrium interest rate on a security if that security cannot be converted to cash on short notice and close to the original cost.
9. Maturity Risk Premium – a premium reflecting interest rate risk i.e risk of capital losses which investors are exposed to because of hanging interest rate over time.