Interest rates are not very exciting, but having a basic knowledge of them can save a whole lot of pain.
Easy to find elsewhere, I will not expand further here, but unfortunately, we do need a few words in bank speak to understand capital destruction.
The interest rate that the government pays on "our" national debt is called the yield. The yield can be called the market rate, the interest rate that the market is willing to accept to own the UK's interest payments. The yield is a simple calculation based upon the coupon payable on the loan and the price one can buy and sell that debt for.
Then there is the base rate, with which banks borrow from the Bank of England, and probably the most important interest rate is LIBOR; The London Interbank Offered Rate, the rate that banks can borrow from each other.
As of writing, these interest rates are roughly:
- Yield – 3.5% for 10 year Government debt.
- Base Rate – 0.50% - Banks borrowing form BoE overnight.
- 1 Year LIBOR: 1.5%- Banks lending to each for one year.
With an inflation rate running at five percent, it is plain as day to see that capital is being destroyed at every level.
At 0.50% the Bank of England is literally giving money away at negative 4.5% an after inflation loss.
Which brings me to a recent FT Lex column, May 27th, (subscribers only) discussing the miracle of compounding interest rates. Very entertaining, almost festive, article. That is until the end.
It is written as a script of a father explaining to a son Einstein's quote on the miracle of compound interest, and the latest government back savings bond. It ends:
"Because that's the rate of interest you'd need to earn to pick up the equivalent of the 0.5 per cent. If you earned 10 per cent, first you'd have to pay tax on that, which would bring it down to 6 per cent. Then you'd need to subtract the rate of inflation, which is more than 5 per cent."
"It sounds to me that we should find a savings account that pays 10 per cent after tax and inflation, in order to take full advantage of the most powerful force in the universe."
[Another pause. The aimless rummaging begins again.]
"Dad, we need a savings account paying more than 25 per cent interest. Is there one?"
"Not at the moment, dear."
"Anything close?"
The answer to that we all know.
