Effec of higher interest rates on UK Economy

• An increase in the base interest rate will lead to an increase in the general cost of borrowing, throughout the economy. 
• Also higher interest rates increase the return on saving money in an interest bearing account.
• Therefore consumers will be less willing to borrow, e.g. on credit cards and personal loans. 
• Consumers with variable mortgages will have an increase in monthly payments, therefore, they will have a reduction in disposable income. 
• This will cause a significant fall in consumer spending, because, in the UK many home owners have mortgage payments, which account for a high % of their income. (This is as a result of rising house prices)
• Similarly, the increase in borrowing costs will also reduce business investment.
• Therefore with a fall in consumption and investment there is likely to be a fall in Aggregate Demand, or more accurately, AD will increase at a slower rate.
• Therefore higher interest rates tend to reduce the rate of economic growth and inflation.

Evaluation of higher interest rates

However, the effect of a rise in interest rates depends on various factors.

1. Effect on savings (income and substitution effect)

Higher interest rates encourage savings and therefore reduce consumption (substitution effect). However, higher interest rates also increase income, for those with high levels of savings(income effect). Therefore, some consumers may actually increase spending. For example, in Japan many firms are currently investing out of savings. Therefore, an increase in interest rates is unlikely to discourage investment. In the UK, levels of debt are high and the savings ratio low, therefore, rising interest rates will be more likely to reduce investment and consumer spending in the UK.

2. The state of the economy

If the economy is growing above the trend rate of economic growth and is close to full capacity, a rise in interest rates will have the effect of moderating growth and reduce inflation. However, it is unlikely to cause a recession because the rest of the economy is buoyant. For example, higher interest rates in the late 1980s didn't cause a downturn initially because the economy was buoyant. Though eventually high interest rates of 1990-92 did cause a recession.

3. Depends on consumer confidence

The effect of a rise in interest rates is sometimes hard to predict. If consumer confidence is high then rising interest rates may not discourage spending; people may just be willing to pay more interest. However, at other times a rise in interest rates may adversely effect confidence; therefore, the effect will be much greater. E.g. In the UK, many are concerned about the booming housing market, they feel the boom could soon turn to bust. A rise in interest rates could be the catalyst to stop house prices rising. If house prices fell it would have a significant impact on reducing consumer spending.


4. Effects on exchange rate

Higher interest rates cause hot money flows, because it is more attractive to save money in the UK. Therefore, this will cause an appreciation in the exchange rate. An appreciation will make exports more expensive and imports cheaper. Assuming demand for exports and imports is relatively elastic, then an appreciation will reduce the growth of AD and help reduce inflation. In the UK, the exchange rate has been strong during the past year. Some experts argue it is fundamentally overvalued. Therefore, a further appreciation in the exchange rate would definitely not be welcomed by the exporting sector.

5. Time lag

It is estimated interest rate changes can take up to 18 months to have its full effect. Therefore, an increase in interest rates now, may reduce growth in the future. However in the UK interest rates have been increased from a low of 3.5% in 2003. Therefore, previous interest rates will begin to have an accumulative effect.

See also:

• Effect of cutting interest rates
• Evaluation of MPC in controlling inflation
• Effects of increasing interest rates in UK

What determines effectiveness of Monetary Policy in UK?

The aim of monetary policy is to achieve the governments inflation target of CPI= 2% +/-1. They will also consider impact on economic growth and unemployment. But control of inflation is their primary objective.

Factors which determine success of Monetary Policy

1. Accuracy of inflation forecasts. Monetary policy is pre emptive which means they try to reduce inflationary pressures before they occur. If inflation is higher than predicted, then interest rates will be too low to control inflation. Inflation predictions could be wrong if there is an unexpected rise in cost push inflation, for example an increase in the price of oil. In the past 15 years the MPC have benefited from generally low global inflation, However some economists feel that this “golden era” of price stability may not continue indefinitely. E.g. economic shocks associated with rising commodity prices.
   

2. Time lags. It is estimated interest rate changes can take upto 18 months to have their full effects. For example if interest rates rise then people who are currently spending on investment will not stop straight away. They will continue with their project. However higher interest rates may deter future projects from starting. By the time interest rates have had their desired effect it may be too late to reduce inflation. (This is why the MPC is always trying to predict future inflation trends)
   

3. Interest Elasticity of Demand. This measures how responsive demand is to a change in interest rates. For example if consumer confidence is very high then higher interest rates may not deter consumer spending. This is because people expect to make more money in the future so are willing to borrow at higher levels of interest.
   

4. Effects of interest rates not equally shared. The effect of rising interest rates effects some much more than others. For example in the UK many have high levels of debt through mortgages. Thus first time buyers with large mortgages will be effected by interest rate changes much more than older people who have paid off most of their mortgages. To reduce inflation may cause financial hardship for a small % of the population who have very high levels of mortgage debt.

5. Other Variables. Interest rates effect other variables in the economy. Higher interest rates increase the value of the £ (through hot money flows). This causes problems for exporters and may worsen current account. Higher interest rates also have a disproportionate effect on the volatile UK housing market.

6. Inflation expectations. The success of monetary policy depends upon credibility of the Monetary authorities. If people have low inflation expectations then it is much easier to keep inflation low. Since independence the MPC have benefited from a reduction in inflation expectations. This is partly due to the credence people give to an independent body rather than politicians with a poor track record of keeping inflation low.

7. Levels of Government debt. High levels of government debt generally put upward pressure on interest rates. This is because to attract enough people to buy government bonds interest rates on these securities need to rise. This puts upward pressure on interest rates throughout the economy.

Note in Japan Monetary policy became ineffective because they experience deflation. Because interest rates cannot fall below 0% this meant the Japanese real interest rates were too high for the state of the economy. Monetary policy could not be used to reflate the economy. However deflation is unlikely to be a real problem in UK for the foreseeable future.

See also: Should primary objective of the UK be low inflation of 2%?

An Evaluation of the MPC in Controlling Inflation

How Effective have the MPC been in meeting the Governments inflation target?

The MPC are responsible for setting interest rates and determining UK monetary policy. They seek to keep inflation close to the government’s target of CPI 2% +/-1 %

Currently (Feb 2007) inflation in 2.7%
Note: I've updated this post in the aftermath of the credit crisis (2013)

Advantages of MPC in setting interest rates.

1. They are independent. They are not subject to political pressures. E.g. they are not tempted to keep interest rates low before an election. This used to be a problem for UK economy, with many experiences of boom and bust economic cycles.

2. Monetary Policy is pre-emptive. They try to prevent inflation before it occurs. They predict future inflation trends. If inflation looks to be increasing above the govts target then they can increase interest rates to reduce consumer spending and keep inflation on track.

3. MPC have reduced inflation expectations. People have confidence that inflation will remain low. Therefore wage demands are lower and it becomes easier to keep inflation low.

4. By targeting inflation directly they get the best overall picture of the economy rather than focusing on small aspects like the money supply.

5. Since 1997 UK inflation has remained close to the government’s target of 2%. This is much lower than UK inflation in the 1980s which reached 10%

6. Interests rates have a powerful effect in influencing UK consumer spending. This is because many people have mortgages or other types of loans.


Limitations of the MPC’s Effectiveness

1. Inflation is low but this is partly due to global pressures keeping inflation low. E.g. globalisation, low prices of raw materials and better technology. If these factors were to increase it would be much more difficult for the MPC to keep inflation low.

2. Interest rates have a time lag. It is estimated it takes 18 months for interest rates to have an effect. Therefore it becomes difficult to control inflation solely through interest rates.

3. Some sections of the economy do not respond to higher interest rates. For example the recent rises in interest rates have not stopped house prices rising. Many older people have a small mortgage therefore changes in interest rates have little effect. However interest rates have a disproportionate effect on people who have just joined the housing market ladder.

4. It depends upon other components of AD. E.g. if consumer confidence is high then raising interest rates may have little effect on reducing consumer spending.

MPC have done a good job so far. However the real test may come when there is a rise in structural inflation or global instability.

See: Evaluation of MPC and ECB in aftermath of the credit crisis (2013)