Tuesday, January 10, 2012

Link Between Inflation and Interest rates

  • Interest rates can influence the rate of inflation and the rate of economic growth.
  • The Bank of England change the 'base' interest rate to try and target the government's inflation rate of 2% +/-1
  • Generally, an increase in inflation, leads to higher interest rates.
  • A fall in inflation rate, and lower growth leads to lower interest rates.
Graph Showing Inflation and Interest Rates in the UK

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Real Interest Rates

  • Typically, nominal interest rates are 1 - 2 % higher than inflation. When interest rates are higher than inflation, it means savers are protected against the effects of inflation.
  • However, in 2008 and 2011, we had a period of negative real interest rates. This meant the inflation rate was higher than the base rate.
  • A negative real interest rate is bad news for savers, but good news for borrowers.

Response to Rising Inflation

  • If inflation rises, generally, the Bank of England increase interest rates to reduce inflationary pressure.
  • Higher interest rates tend to reduce consumer spending. This is because homeowners see an increase in the cost of their mortgage payments and have less disposable income. Therefore, they spend less. Also, higher interest rates increase the incentive to save and reduce the incentive to borrow.
  • Therefore, an increase in interest rates tends to reduce the rate of economic growth and prevent inflationary pressures.
  • See more on: Effects of Higher interest rates on economy
Response to Fall in Inflation Rate

If inflation falls below the target, there is likely to be a fall in the rate of economic growth, and the Central Bank may fear a recession. Therefore, in response they may cut interest rates to try and boost economic growth.
  • Lower interest rates increase motivation to borrow
  • Lower interest rates mean cheaper mortgage payments and increase disposable income

Why A Cut in Interest Rates May Not Work

In some situations, cutting interest rates may be ineffective in boosting economic growth. For example, in 2008-11:

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  • The recession was so sharp, that investment and consumption have fallen dramatically and so the cuts in interest rates have only mitigated the extent of the downturn
  • House Price falls provide a powerful negative impact on spending. Lower interest rates should boost spending. But, with house prices falling 20% since the peak, this has reduce consumer wealth and therefore reduced spending.
  • Global downturn. Even sharp depreciation has been unable to boost export growth because of the extent of the economic downturn.
  • Time Lags. A cut in interest rates can take a long time to have an effect. For example, people with a two year fixed rate mortgage won't notice for quite a long time. (until they re-mortgage. Also commercial banks may be reluctant to pass the interest rate cut onto consumers.

Why Higher Inflation May not Cause Higher Interest rates

  • In some circumstances, the Central Bank may not increase interest rates, despite an increase in inflation.
  • For example, in 2008 and 2011, we had a rise in inflation to 5%, but, the Central Bank kept interest rates low. Why?

They kept interest rates low because:

  • They felt inflation was just due to temporary cost-push factors like higher taxes and volatile food prices increasing
  • They felt economy was at risk of inflation. Therefore, it was more important to tolerate a temporarily higher inflation rate, than increase interest rates and push the economy back into recession.

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