The Price of Money

And so of everything else

Let’s start with the conclusion

If you buy a BD 100,000 house with a 25-year mortgage loan at 5%, you pay around BD 75,000 in interest over the life of the loan. At 6%, it’s BD 93,000 — almost BD 20,000 higher (!). For large sums of money over long periods of time, even seemingly minor changes in interest rates really matter.

Some background

Taking a basic macroeconomic perspective, interest rates come in two sizes — short- and long-term. Central banks operate at the short end of the curve by setting monetary policy on how much it costs for commercial banks to borrow liquid funds, with rates targeted for overnight to one month tenors. In Bahrain, the CBB’s key policy rate is its 1-week deposit rate. Longer-term rates are correlated with these short-term set-ups, but are priced by the market after accounting for economic conditions, credit risks, duration risks and inflation forecasts.

In theory, central banks cut their rates when the economy is slowing, to encourage borrowing and stimulate economic activity, and raise them when things start getting too hot and prices are rising, to encourage saving. Commercial banks then do the same for clients, at least to an extent, based on their own perceptions of the macro environment.

However, Bahrain’s monetary policy — i.e. the CBB being able to decide on short-term rates — is hamstrung by its exchange rate with the US Dollar. Because…