Interest rates and inflation: what you need to know.
When central banks raise interest rates, the ripple effect hits each of us, from businesses to households. Here's how this works & why you should care.
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In this edition, learn about:
Why should you care about rising interest rates?
What are interest rates?
What do central banks do?
How do raised interest rates affect consumers?
How do raised interest rates affect businesses?
The challenge and risks
Bonus cartoons!
Why should you care about rising interest rates?
When central banks raise interest rates its big news. And it has an effect on all of us - businesses, households, the whole economy.
The bank is judging that the only way they can try to pull down inflation is to carry on raising interest rates. We're seeing rising interest rates that make the cost to borrowing go up and it has a ripple effect across the whole economy:
Sinks consumer confidence
Leads to lower job creation
Lower wages
Causes stock prices to fall (if they go too far too fast)
And ultimately, tip economies into recession
What are interest rates?
Let's start with their connect to all of us, when rates are higher:
If you borrow money you'll have to pay back a little extra to make it worthwhile for the lender
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 by the interest rate that the central bank sets.
What do central banks do?
They are like a bank for banks, just like you and your savings account, banks also earn interest when they leave money with a central bank.
Example: Commercial banks have these things called reserves so that's a bit like their cash on hand. These 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.
In each part of the world, the central bank is referred to by different names. For example:
“The Fed” in the US
“The Bank of England” in the UK
“The Reserve Bank of Australia” or RBA in Australia
Essentially, when central banks raise interest rates they are trying to control inflation.
Inflation is how fast prices rise for everyone and it’s worth nothing:
General consensus for all central banks is to be as close to or hit an inflation target of two percent
Rates are a really powerful tool, especially if inflation is seen as too high because that's when banks raise interest rates, the change spreads through the financial system and slows down the rate of inflation.
How do raised interest rates affect consumers?
A rise in interest rates from a central bank means that a commercial bank (e.g. CBA, Westpac, ANZ etc) will earn more on their reserves. They might make more from keeping their money in a central bank then lending it out so if they do lend it out they'll raise their interest rates to make it worth their while
In countries 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
Therefore, the goal is that this lower spending should translate into lower inflation
How do raised interest rates affect businesses?
It's not just consumers who will tighten the purse strings.
When interest rates rise, businesses find it more expensive to borrow and invest which 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 will make businesses more reluctant to raise their prices and that will tend to pull back inflation
The challenge
It sounds straightforward right but the trick is judging how far to go.
For example, 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.
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 five percent without causing a recession.
A little inflation is okay as it keeps the economy moving at a sensible speed but inflation staying high for too long is a problem. Why?
Higher prices = employees needing higher wages = increased costs for businesses = businesses increasing prices further, potentially leading to an upward spiral of wages and prices.
In India for example, retail inflation has surged to 7.8 percent, the combination of a slowdown in 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 two percent 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.
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 the central bank's 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 to get low and steady inflation so that in the long run you don't have to think about it.
Bonus!
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