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Who Determines Interest Rates?



By Vivian atud

I get this question a ton – who determines interest rates in the economy, the markets or the South African Reserve Bank? In my view the answer. It shouldn’t be controversial that the SA Reserve Bank could, in theory, control the nominal rate of interest on South African government issued debt. As the monopoly supplier of reserves to the banking system, they can effectively set a ceiling on interest rates by making a market in bonds. Bond traders don’t fight the Reserve Bank because they know the Reserve Bank is the monopoly reserve supplier. You can’t beat the Reserve bank’s printing press. Therefore, “bond vigilantes” in South Africa are an overstated risk in general.

This seems to give the appearance that the Fed determines interest rates. But there are many more interest rates in the economy than the repo rate or the rates on SA government bonds. Yes, these are important benchmark rates, but they are just benchmark rates.

Most importantly, it’s crucial to understand the context in which interest rates are set at a certain level. For instance, in an environment of high inflation the Reserve Bank is likely to respond to the state of the economy by raising interest rates. The Reserve Bank can’t control the economy and generally reacts to the state of the economy. In addition, the market rates on other interest rate products are likely to rise in a high inflationary environment even if the Reserve Bank were to keep repo rates low. If a bank can charge you a higher real rate on bank loans because the economy is stronger then, the difference between the benchmark rate and the lending rate just makes it more profitable for the banks to issue loans. This could also become inflationary and so the reserve bank is very likely to respond to a high rate of inflation by raising interest rates. Therefore, the Reserve Bank responds to the state of the economy.

Anyhow, the point here is that neither the Reserve Rank nor the markets determine interest rates. The state of the economy will lead the markets and the Reserve Bank to respond in certain ways which may or may not lead to interest rate changes. But make no mistake, while bond vigilantes aren’t going to push the rate of interest on SA government bonds higher if the reserve bank doesn’t want them higher, the reserve bank also can’t control the rate of interest on all credit instruments. In other words, the reserve bank can control the nominal rate of interest on SA government bonds, but it can’t control the entire economy. So, as is generally the case, the answer to this question isn’t quite as black and white as many would assume.

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