What are interest rates and how do they work?

• What are interest rates?
• What are base rates?
• How do base interest rates work?
• How do central banks change rates?
• Why are interest rates changed?
• Trading interest rates
• Why trade interest rates?
• How trading interest rates works
• How to trade interest rates
• What moves interest rate markets?
• Interest rates FAQs

What are interest rates?

Interest rates are the amount you pay to borrow money, or what you’ll receive when you save money. When you keep money in a bank account, that bank will typically pay you interest on your savings because you are in effect lending them cash.

At the RBA the interest rate is known as the cash rate which is the Australian base rate.

Interest rates on loans are shown as a percentage of the total amount borrowed (the principal). For example, if the loan is $100,000 with a 5% annual interest rate (most rates are annual by default), the total owed to the lender in interest would be $5000 in the first year.

In terms of savings, if interest rates are 5% annually and you have $10,000 in an account, you’ll have $10,500 by the end of the year – assuming interest is paid once each year.

Although commercial banks set their own rates, they aren’t the most important interest rates to traders. They are much more interested in base rates.

What are base rates?

Base rates are the amount charged by central banks to commercial banks to borrow money – and also the amount of interest paid on money held with the central bank. Base rates are seen as benchmarks, with commercial banks’ interest rates largely influenced by the base rate that’s set.

Setting the base is part of a central bank’s monetary policy. It’s the job of central banks like the Federal Reserve (Fed), European Central Bank (ECB) and People’s Bank of China (PBoC) to help support the economy they reside over by managing monetary policy and ensuring commercial banks continue to operate successfully.

Base rates tend to have a major effect on lots of markets, including forex, shares and bonds.

How do base interest rates work?

Base interest rates work by setting a rate at which a central bank is willing to lend money to other banks or pay to those holding money with them. This should trickle down to the rates charged by commercial banks, meaning a change in the base rate will in turn cause a shift in the actual interest rates that banks are offering savers and charging lenders.
 
For instance, if the Reserve Bank of Australia (RBA) decides to raise the base rate, it would mean banks will pay more for loans when they borrow money from the RBA. Banks react to this by subsequently raising their interest rates, so they’ll also receive more money from those who they lend to.  

Even the slightest change in interest rates can have a significant impact on the economy. As such, changing them is a decision that’s not taken lightly. Most central banks have selected committees comprised of several financial experts and economists who will debate monetary policy and ultimately decide whether or not to change the interest rate.

How do central banks change rates?

Each central bank amends its base rate slightly differently.

For instance, the RBA has the Reserve Bank Board that is made up of nine members that meet on the first Tuesday of each month, except for January. Each member has an equal vote on any proposed action that’s put forward, and the outcome is relayed to the public via a media release which is published on the Reserve Bank’s website at 2.30pm on the day of meeting. 

Here’s a rundown of the processes at some of the other major global central banks:

*Monetary policy meetings only.

Why are interest rates changed?

Central banks change interest rates to maintain a delicate balancing act between growing the economy and keeping inflation in check.

• They lower rates to encourage spending and try to stimulate the economy
• They raise rates to encourage saving and try to stabilise inflation

In times of crisis, economic hardship or simply during periods where the central bank feels the economy is not quite performing as well as it should, interest rates might be lowered.  

This will lower the return for those people who are saving their money in interest-paying bank accounts, which simultaneously encourages people to spend their money rather than save it. Furthermore, the increase in spending in the economy equates to a rise in demand for goods, which pushes their prices up.  

On the other hand, interest rates can be raised to encourage saving. If the central banks raise interest rates, people saving money will get a greater return on their investment. Therefore, there is less incentive for people to choose to spend their money, and saving could increase.  

If people are saving more money, that means less is in circulation in the economy. With less being spent, demand for goods falls and so too does the prices of these goods. This is how a reduction in interest rates can help to ease inflation – the BoE has a 2% inflation target, so anything greater than 2% could be cause for concern and action may be needed to reduce it.  

Trading interest rates

We’ve established that interest rates are significant to economies, but how does this all relate to trading? Firstly, considering the correlation between economic performance and certain markets, interest rates can influence a lot of people’s trades. 

Forex, stocks and indices are all heavily affected by changes in interest rates. Gold or futures markets are among others that could see volatility based on a change of interest rates.  

Plus, with City Index you can trade some of the most popular interest rates as individual markets.

Why trade interest rates?

Trading interest rates not only diversifies your portfolio and provides an opportunity to make money from rate moves, but they can also be used to hedge against the risk of a rate moving and negatively impacting your open trades. 

Trading interest rate markets is the only way to directly make the most of any change in rates made by central banks. Other markets can move based on a change of rates, but other factors will also impact their prices. Whereas, when trading interest rates, you get 100% exposure to any change made by central banks.  

By trading interest rates, you can hedge your risk on an interest-related asset like a bond or a loan. It’s also the opportunity to trade a less conventional market and make the most of rate movement in either direction. 

Find out more about trading interest rates with City Index.

How trading interest rates works

The price of an interest rate market aims to emulate the actual value of an interest rate. So, if rates rise then the corresponding interest rate market should also rise.  

The price of an interest rate market is calculated by subtracting the actual rate from 100. So, if the ECB sets the eurozone’s interest rate to 4%, the corresponding Euribor market would be 96 (100 – 4%).  

How to trade interest rates

Follow these steps to start trading interest rates today:

1. Open your City Index account


2. Pick which market you want to trade


3. Choose to go long or short


4. Decide the amount you want to trade


5. Set your stops and limits


6. Open the position

Get started with a City Index account and start trading interest rate markets today. Not ready for the real thing? Test out the markets with our free demo account instead.

What moves interest rate markets?

We know the decision to change base interest rates comes from each respective central bank, but what fuels that decision and what factors do individual banks consider when setting their own rates?

Geopolitical shocks

Geopolitical shocks like international conflicts or pandemics can have a huge impact on an economy. Shocks can devastate economies as these often come suddenly and don’t allow any time to prepare for the impact. What’s more, as we saw with the Covid-19 pandemic, the effects are typically damaging and long-lasting. As a result, central banks use interest rates to attempt to limit the impact.

Since the turn of this decade, several central banks have chosen to lower interest rates and set them below 0% so that they’re negative. It’s seen as a risky form of action and as such, negative rates have been the focal point of much deliberation among many of the major central banks.

Employment

A main target for central banks to focus on is employment. Low unemployment benefits an economy as it means more people are in work and earning disposable income that could then be circulated back into the economy.

When rates are low, it’s cheaper for companies to take out loans and expand their business, which in turn creates more jobs. If a central bank wants to help lower unemployment, it may lower interest rates. It’s therefore important to look at employment levels when trading interest rates, as the two are closely linked with one another.

Inflation

Inflation in an economy is a major factor in dictating interest rates. When inflation is high, central banks will set rates high to try to encourage saving and stem the rise in prices of goods and services. Equally, banks will raise their interest rates to compensate for the reduction in purchasing power for the money they’re owed.