We often hear the term Interest Rates on the news but only a few truly understand what it means especially here in the Philippines. It is important to understand the role of Interest Rates in the economy, particularly in the stock market so we can improve our understanding of the economy. The interest rate is the amount charged on top of the principal by a lender to a borrower for the use of assets.
Before we dive into Interest Rates, let us define Inflation first..
The Banko Sentral ng Pilipinas (BSP) defined Inflation as the rate of change in the weighted average prices of goods and services typically purchased by consumers. The weights of the goods and services are based on their corresponding share to the Consumer Price Index (CPI) basket, i.e., the standard basket of goods and services purchased by a typical household.
In the Philippines, the composition of the CPI basket is determined by the Family Income and Expenditure Survey (FIES) periodically conducted by the Philippine Statistics Authority (PSA) formerly National Statistics Office (NSO). Inflation is typically defined as the annual percentage change in the CPI. It indicates how fast or slow the CPI increases or decreases. Headline Inflation – the rate of change in the weighted average prices of all goods and services in the CPI basket.
Inflation and interest rates tend to move in the same direction because interest rates are the primary tool used by the Federal Reserve, and the BSP, to manage inflation. The BSP’s main responsibility is to formulate and implement policy in the areas of money, banking, and credit with the primary objective of preserving price stability. Price stability refers to a condition of low and stable inflation. By keeping prices stable, the BSP helps ensure strong and sustainable economic growth and better living standards for Filipinos.
Inflation targeting is focused mainly on achieving a low and stable inflation, supportive of the economy’s growth objective. This approach entails the announcement of an explicit inflation target that the BSP promises to achieve over a given time period.
As for the Peso(PHP), higher interest rates increase the value of a country’s currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country’s currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency’s.
How are Stocks affected?
When interest rates rise, it also makes it more expensive for companies to raise capital. They will have to pay higher interest rates on the bonds they issue, for example. Making it more costly to raise capital could put a damper on future growth prospects as well as near-term earnings. The result could be a revision downward in profit expectations going forward as rates increase. So if interest rates are high, companies might hold off future expansion plans or expenditures.
If a company is seen as cutting back on its growth or is less profitable—either through higher debt expenses or less revenue—the estimated amount of future cash flow will drop. All else being equal, this will lower the price of the company’s stock.
However, some sectors stand to benefit from interest rate hikes. One sector that tends to benefit the most is the financial industry. Banks, brokerages, mortgage companies, and insurance companies’ earnings often increase—as interest rates move higher—because they can charge more for lending.
Interest rates in the Philippines 5yr chart
Interest rates and inflation tend to move in the same direction but with lags, because policymakers require data to estimate future inflation trends, and the interest rates they set take time to fully affect the economy. Higher rates may be needed to bring rising inflation under control, while slowing economic growth often lowers the inflation rate and may prompt rate cuts.
Basically, Higher interest rates tend to negatively affect earnings and stock prices (with the exception of the financial sector). Higher interest rates also mean future discounted valuations are lower as the discount rate used for future cash flow is higher.
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