Interest Rates and Central Banks
A single number set by a handful of officials in Washington or on Robinson Road ripples out to touch your grandmother's fixed deposit, your favourite tech stock, and the price of a home loan — this lesson explains why interest rates are the single most powerful lever in modern finance.
What central banks do: MAS and the Federal Reserve
A central bank is a country's official monetary authority — its job is to manage the money supply and keep the financial system stable, usually with a mandate to control inflation and support employment. The US Federal Reserve ("the Fed") is the world's most closely watched central bank, because the US dollar and US interest rates influence financial conditions globally. The Fed's main tool is the federal funds rate, the interest rate at which banks lend to each other overnight, which ripples out to affect nearly every other interest rate in the US economy.
Singapore's central bank, the Monetary Authority of Singapore (MAS), works differently, as you saw in the previous lesson: rather than setting a policy interest rate directly, MAS manages the exchange rate of the Singapore dollar against a basket of currencies, because Singapore's economy is so trade-dependent that the exchange rate is a more effective lever than a domestic interest rate would be. Both institutions share the same underlying goal — keeping prices stable and the economy on an even keel — they just pull different levers to get there.
How interest rates affect borrowing, spending, and investment
Interest rates are, fundamentally, the price of money. When rates are low, borrowing is cheap: mortgages, car loans, and business loans all cost less to service, which encourages households to spend and companies to invest in growth — hiring, building new factories, launching new products. When rates are high, borrowing becomes expensive, so households cut back on big-ticket purchases and companies delay expansion plans, since the cost of funding them has risen. Interest rates also affect the appeal of saving versus spending: higher rates mean savings accounts and fixed deposits pay more, nudging people to save rather than spend today.
Rate hikes to fight inflation: the mechanism
When inflation runs too hot (recall Lesson 5.2), central banks typically respond by raising interest rates — a rate hike. The logic runs in a clear chain:
This is a blunt tool with real costs: cooling demand also tends to slow hiring and economic growth, which is why central banks try to raise rates just enough to tame inflation without tipping the economy into a deep recession — a very difficult balancing act often described as engineering a "soft landing."
How rate decisions ripple through stock and bond markets
You've already seen one direct channel in Unit 4: rising interest rates push existing bond prices down, because newly issued bonds now offer better yields, making older, lower-coupon bonds less attractive at their old price.
Stocks are affected too, through a few connected channels. First, higher rates raise the cost of borrowing for companies, squeezing profits for businesses that rely heavily on debt to fund growth. Second, and more subtly, higher rates change how investors value future profits: a dollar of profit expected five years from now is worth less today when interest rates are high, because investors could instead earn a decent, safe return simply by holding a bond today — this is the same time-value-of-money logic from Unit 1, just applied to valuing a whole company (you'll cover this valuation mechanic in depth in Unit 9). Third, rate hikes often coincide with the slower spending and investment described above, which can directly reduce company revenues and profits.
Why growth stocks are hit harder than value stocks
Growth stocks are companies expected to generate the bulk of their profits well into the future — think of a young tech company reinvesting everything into expansion rather than paying it out today. Value stocks are typically more mature, established companies already generating solid, steady profits today. Because growth stocks derive most of their valuation from profits expected many years from now, they are hit disproportionately hard when rates rise: those distant future profits get "discounted" more heavily at a higher interest rate, shrinking their present value by a larger percentage than a value stock's more immediate profits are shrunk. This is why growth-heavy sectors like technology tend to sell off more sharply than value-heavy sectors like banks or utilities whenever the market expects rate hikes.
If the Fed raises interest rates, why might growth stocks fall more than value stocks?
Reveal Answer
Growth stocks derive most of their value from profits expected far in the future, while value stocks generate most of their profits today. When interest rates rise, future cash flows are "discounted" more heavily — a dollar of profit expected in 10 years becomes worth noticeably less in today's terms when rates are higher, because investors could otherwise earn a decent guaranteed return elsewhere in that time. Since a much larger share of a growth stock's valuation sits in those distant, heavily-discounted years, its total value shrinks by a larger percentage than a value stock's, whose profits (and therefore valuation) are weighted much more toward the near term and are less sensitive to the discount rate.