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Interest Rates are Uninteresting – But This is Why They Matter

Guest writer Zizi Francis offers an economic explainer on interest rates, inflation and economic growth following the collapse of Silicon Valley Bank and the difficulties of Credit Suisse.

News about interest rates seems to be more or less inescapable nowadays, considering the context of continual rate hikes, inflation and the wobbling banking system. But surrounded by technical jargon and an unending list of acronyms, most people’s interest rate in interest rates drops swiftly to zero. Considering their importance, however, it is worth understanding what interest rates are, why they are increasing and what it means for the world.

What Are Interest Rates?

In their most comprehensive definition, interest rates are the price of money, the cost of borrowing and the profit from lending. Central banks, however, do not have direct control over all of the interest rates in an economy. Rather, they only can establish short-run, nominal interest rates. Longer term yields, on the other hand, are determined by the demand for longer term bonds. (Central Banks can exert some influence through quantitative easing and quantitative tightening, however, they cannot set these rates in the same way they can the short-run rate). Various other rates, such as those on mortgages and other loans, are set by the commercial banks.

When we see ‘interest rates going up’ in the news, this refers to the central bank-determined rates. The names for this rate are different in each country. In the UK, the Bank of England sets the ‘Bank Rate’; in the US, the Federal Reserve determines the ‘Federal Funds Rate’.

The rates announced by central banks are the annualised rate at which banks can borrow and lend to each other in the overnight market, which they may need to do in order to meet the liquidity requirements put in place by many governments. Liquidity requirements are set amounts of ‘cash on hand’ which banks need to avoid being caught empty-handed.

Why Are Interest Rates Going Up Now?

Monetary policy is the adjustment of interest rates by central banks. When interest rates are increased, this is tight monetary policy, while loose monetary policy is the lowering of interest rates. High interest rates are implemented to ‘cool’ an economy, to reduce the total level of spending and output. In contrast, low interest rates stimulate the economy by encouraging increased spending and thus economic growth.

In response to the spread of Covid-19, central banks worldwide slashed interest rates. In April 2020, the Bank of England lowered rates to 0.10%; the Federal Reserve cut rates to 0.05%. They took this decision in order to stimulate economic activity in response to lockdowns, as well as plummeting consumer and business confidence.However, even before this crisis, interest rates had been at historic lows for a prolonged period of time, with some central banks, such as the European Central Bank and the Bank of Japan, utilising negative interest rates. In effect, they would pay banks for taking out loans and charge them to store money at the central bank.

By 2021, however, concerns about inflation began to outweigh concerns about low growth. In August, annual inflation in the UK – measured by the Consumer Price Index – was 3.2%, above the target inflation rate set by the central bank at 2%. Although the specific goal of 2% is somewhat arbitrary, central banks across the world target this level of inflation. Some inflation is desirable, as it is associated with economic growth. However, to maintain a healthy economy, the inflation level must be low and stable. The most recent report from the Office of National Statistics (ONS) measures British annual inflation at 10.4% for the year preceding February 2023. The reasons for current inflation are varied – many important factors are still being debated by economists.

Yet what is not a topic of contestation, is that increasing inflation rates are undesirable. Rising inflation makes it harder for people, especially those on a fixed income, to afford what they previously could. It results in greater uncertainty, as the pound in your pocket is worth rapidly less. It imposes additional costs, as businesses adjust to changing prices;  these are termed ‘menu costs’.

Furthermore, the longer inflation is present, the more likely it is to continue, as expectations become entrenched. Unexpectedly high inflation can lead to a ‘wage-price spiral’. In response to greater inflation, workers may demand higher wages to keep up with the increasing cost of living. As a result, costs for firms increase, and so they will pass this on to consumers through raising prices. As these individual choices aggregate, they lead to even higher levels of inflation, and the cycle continues. Additionally, in circumstances of high inflation, consumers chose not to delay purchases, as these purchases would be more expensive in the future. This increases demand for many goods, and so prices rise, as does inflation. This is why central banks, including the Bank of England, have taken swift and steadfast action by raising interest rates.

How Do Interest Rates Impact Inflation?

Although the Bank Rate is only directly applied to overnight lending between banks, it has ripple effects for the wider economy. When the costs of saving and lending change for banks, they pass these costs and windfalls on to the consumer.

As it becomes more expensive for banks to borrow from each other – the Bank Rate going up – they discourage their consumers from borrowing themselves. They do this by increasing interests rates on, for example, credit cards and mortgages. In theory, they should also increase the interest rate on savings accounts to incentivise household saving. It is now more expensive to take money out of a bank and more profitable to put it in. This would mean more deposits into the banks. (In practice, these rates may not immediately reflect changes in monetary policy – but this is the idea.)

Inflation is a complicated phenomenon. At its most basic level, however, inflation is ‘too much money chasing too few goods’. To quell inflationary pressure, there must be either less money or more goods. Interest rates impact the ‘too much money’ portion of this equation; the demand side of the economy. As interest rates rise and it becomes more expensive for households to borrow and more lucrative for them to save, consumers change their behaviour accordingly. People buy less things and save more money. As demand falls across the economy, there is less competition between consumers for the scarce goods and services available. Like magic, prices should not increase as rapidly.

Why Does This Matter?

The immediate way that most individuals are affected by central bank rate hikes is through increases in the interest rates they interact with from commercial banks, on savings accounts or on student loan repayments, for example. Interest rates are felt through the entire economy – they cannot change the inflation rate without impacting consumption and saving patterns. The entire economy is affected: intertest rates are not a silver bullet.

The recent collapse of Silicon Valley Bank (SVB) was (in part) a result of increasing interest rates. As they rose, the value of long-term government bonds the bank had purchased fell because more recently issued bonds, with their higher interest rates, became more desirable. When depositors wanted to take money out, SVB was forced to sell these bonds at a loss. This prompted concerns about their financial security; when word got around, this precipitated a ‘bank run’. Although the Federal Reserve has taken significant action to prevent contagion (other banks being effected by the bank run and collapse), this case illuminates the power of interest rates.

Due to the interconnected nature of the global economy, interest rate changes in one country have an impact around the globe through exchange rates. As interest rates in a particular country rise, foreign investment in the country becomes more desirable because investors can receive a higher return on their lending. This leads to increased demand for the country’s currency. This causes the currency to ‘appreciate’; to become more valuable compared to another currency.

This makes exports less competitive, while imports become cheaper. This can contribute to the disinflation (thanks to cheap foreign goods), but is also an undesirable outcome for export-driven countries. Thus, interest rate increases in one country often result in similar measures being carried out by central banks worldwide, as they attempt to avoid currency fluctuations. This is why the actions taken by the Federal Reserve in the United States are considered to be of such importance for other countries.

The most worrisome possible impact of interest rate increases, however, is the possibility that rate hikes could prompt a recession. As explained, the goal of tight monetary policy is to reduce the total level of demand in an economy, to reduce the spending that occurs. This ‘cools’ the level of inflation, but also means that economic growth slows. As output in the economy falls, firms do not need to employ as much labour and so unemployment can rise. This is also why banks do the opposite during an economic downturn, as during the Covid-19 pandemic.

To some extent, inflation and unemployment are expected to be a trade-off. In recent years, it has been proposed that the relationship between these two economic phenomena may have weakened. However, the current inflationary context has suggested that this trade-off may, in fact, still be present.

We cannot yet be sure if the current interest rate increases will lead to such a situation of unemployment. Central banks are still aiming for a ‘soft landing’, in which inflation is reduced without causing substantially increased unemployment and economic suffering. The most recent forecast by the British Chambers of Commerce predicts that although the economy will shrink in the third quarter of 2023, the UK will manage to avoid a technical recession (a GDP fall in two successive quarters). Regardless, the monetary policy enacted by the Bank of England, as well as other banks around the world, will certainly continue to shape the economy and the all of our lives.

Interesting? Hopefully. Important? For sure.

Zizi Francis

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