When central banks raise interest rates, it’s big news
The bank is judging...
...that the only way they can try to pull down inflation...
...is to carry on raising interest rates
We’re going to see rising rates
Rising interest rates that will make the cost of borrowing go up
It can send ripples across the whole economy
It can sink consumer confidence...
...result in fewer jobs and lower wages, and cause stock prices to fall
If they go too far too fast, it can tip economies into recession
So why do central banks raise interest rates?
Let’s start with the basics
If you borrow money, you’ll have to pay back a little extra...
...to make it worthwhile for the lender
Well, I think we can make you this loan, you have a good reputation...
...we know you’re reliable
I’m glad you think so
This is the interest rate
So if you are taking out a loan...
...you want the interest rate to be as low as possible...
...so you don’t have to pay that much back
On the flip side, if you want to save money...
...then a high interest rate means you can earn more on your savings
See it as a reward for leaving money in your account
But the size of your reward depends on the circumstances
There’s no single interest rate in the economy
You’ve got thousands of banks setting their own commercial rates
That’s all influenced, though, by the interest rate that the central bank sets
A central bank is like a bank for banks
Just like you and your savings account...
...banks also earn interest when they leave money with the central bank
Commercial banks have these things called reserves
So that’s a bit like their cash on hand
Commercial banks lend those excess reserves to each other at an interest rate...
...and they also can deposit their excess reserves at the central bank
And when they do that, they can earn an interest rate
Ordinary people can’t access the interest rate on the excess reserves...
...but it still affects them
And that’s the idea
When central banks raise interest rates...
...they’re trying to control inflation—how fast prices rise for everyone
They were £1.29, now they’re £1.39, and that’s in the space of four weeks
Central banks like the Fed or the Bank of England or the European Central Bank...
...are all trying to hit an inflation target of 2%
Interest rates are a really powerful tool that they have to do that
If inflation is seen as too high, that’s when banks raise interest rates
The change spreads through the financial system and slows down the rate of inflation
Here’s how
A rise in interest rates from a central bank...
...means that a commercial bank will earn more on their reserves
They might make more from keeping their money in a central bank than lending it out
So if they do lend it out, they’ll raise their interest rates...
...to make it worth their while
How that affects consumers depends on the economy
Take mortgages
In places like Finland or Australia...
...lots of people have mortgages with variable interest rates
If you’ve got a variable-rate mortgage, where the interest rate that you pay...
...is linked to the central bank’s interest rate...
...then higher interest rates mean that, essentially, immediately...
...the higher rate will translate into less cash to spend on other things
Less spare cash means households will spend less
And less spending means businesses will be warier of raising prices
This should lower inflation
In other countries, like America or Canada...
...a bigger share of mortgages are set at fixed rates
People with fixed rates are protected...
...against the direct effects of an interest rate rise...
...but will still feel an indirect impact
Higher interest rates mean that mortgages will become more expensive
If that is affecting all new buyers, then house prices will begin to fall
And that will make everyone who owns a home feel poorer...
...and therefore they might spend less
Lower spending will translate into lower inflation
And it’s not just consumers who will tighten the purse strings
When interest rates rise...
...then businesses will find it more expensive to borrow and invest
That generally means less economic activity
It might mean fewer jobs are created
Fewer jobs and lower wages could mean less money for households...
...and consumer confidence might suffer
Which also means less spending
People are grappling with a decline in real wages...
...meaning their money buys less
When interest rates rise, that will tend to slow down spending, investment...
...and generally depress economic activity
Overall that will make businesses more reluctant to raise their prices...
...and that will tend to pull back inflation
It sounds straightforward, right?
But the trick is judging how far to go
In 1981, the Federal Reserve, America’s central bank...
...allowed interest rates to rise to a whopping 19%
The move curbed inflation, but it led to widespread economic pain
I regret to say that we’re in the worst economic mess since the Great Depression
It is very difficult to get inflation under control...
...without severely denting economic activity
In America, it’s been over 70 years since they’ve managed to get inflation down...
...from over 5% without causing a recession
A little inflation is OK
It keeps the economy moving at a sensible speed
But inflation staying high for too long is a problem
Higher prices means employees will need higher wages...
...pushing up costs for businesses
That could drive up prices further...
...potentially leading to an upward spiral of wages and prices
Retail inflation in India has surged to 7.8%
The combination of tepid economic activity and high inflation...
...poses serious challenges for the Indian economy going forward
Central bankers are really concerned about setting expectations of inflation
The idea is that, if it can show that it is credible...
...that it will always act to get inflation back down to 2%...
...then maybe it won’t have to raise interest rates...
...and then lower them in this kind of seesaw fashion
Raising interest rates can slow an economy right down
The trouble is, the brake pedal has a delay
It can take as long as two years...
...to see the full results from interest rate changes
Central banks know this
So when they set interest rates...
...they’re actually trying to read the road ahead
But predicting the future isn’t easy
The problem is it’s difficult for the central bank to work out...
...whether the inflation will fall back on its own
And even when central banks do get it right...
...they might still cause a crash
It may be a blunt instrument, but raising interest rates...
...is still central banks’ main tool for taming inflation
Central bankers would say that, yes, raising interest rates can be painful
Slowing down the economy is not fun
But it’s worth it
It’s worth it to get low and steady inflation...
...so that in the long run, you don’t have to think about it
Thank you for watching
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