An overview of the factors influencing interest rates, and the rationale applied by the Reserve Bank in adjusting short term interest rates Address by Dr Chris Stals, Governor of the South African Reserve Bank, at a meeting of The Weekend Argus/Seeff Trust Investors Club, Cape Town.1. Interest rates determined by market forcesThe interest rate is a very important price that plays a vital role in establishing and maintaining equilibrium in the market for loanable funds. Like all other prices, the interest rate is determined by forces of demand and supply. If the demand for loanable funds tend to exceed the supply of loanable funds, the interest rate will tend to rise, and vice versa, when demand is less than supply, the interest rate will tend to decline. Changes in interest rates emit important signals to the borrowers (demand side) and lenders (supply side) operating in the market for loanable funds. Obviously, an increase in interest rates indicates a shortage of funds, caused by increasing demand or a decline in the supply of funds. An increase in interest rates therefore brings a clear message to borrowers: reduce your demand for loans. At the same time, the higher rates entice potential savers to consume less, that is, to save more and thus make more loanable funds available at the better return. In a market-oriented economy as we have in South Africa, efficient financial markets are essential instruments for the effective functioning of the interest rate mechanism. Interest rates must be flexible and must react in a sensitive way to changes in the underlying market forces. Excessive government intervention in the financial markets will reduce the effectiveness of the price mechanism, and can easily lead to permanent distortions in the flow of funds in the financial markets. Such distortions can lead to chronic shortages of funds, and also to the maldistribution of the available production resources of the economy. In the longer term, unrealistic interest rates, be they too low or too high, will lead to economic growth below the real potential of the economy.In the real world, there are many different interest rates, associated with the maturity of underlying loan agreements, the liquidity or marketability of the financial instruments used, and the risks involved in different kinds of loans. The inter-relationship between different interest rates may also change from time to time, for example the term structure of interest rates. Changes in these interrelationships also often carry important messages. In South Africa, for example, recently the slope of the yield curve for different maturities flattened out, indicating a decline in inflation expectations. The main sources of supply of loanable funds in an open economy are domestic saving and net inflows of capital from the rest of the world. The demand comes mainly from government to finance both current and capital expenditure, from businesses to finance investment in fixed assets, inventories and other trade assets, and from consumers to finance both durable and non-durable consumer expenditure. A net outflow of capital to the rest of the world, as South Africa experienced from 1985 to 1993, reduces the amount of funds available for domestic application. In a country such as South Africa, where gross domestic saving over the past decade declined from about 25 per cent to 17 per cent of gross domestic product; where the deficit on the government's budget now absorbs private saving to an amount equal to about 6 per cent of gross domestic product (against a more normal 3 per cent of gross domestic product); where new fixed investment is growing at a rate of about 10 per cent per annum and real inventory accumulation amounted to R11,0 billion over the past eighteen months, and where private consumption expenditure is growing at a steady 3½ per cent per annum, interest rates must and will be high. Were it not for the net capital inflow of about R20 billion since the middle of 1994, the level of interest rates would have been much higher in South Africa at this stage. In