How does raising interest rates control inflation?

The Economist

9 Jun 202208:14

Summary

TLDRCentral banks play a critical role in managing inflation by adjusting interest rates. When inflation is perceived as too high, these banks increase interest rates, which in turn raises the cost of borrowing and can lead to a decrease in consumer confidence, job creation, and wage growth, potentially causing stock prices to fall. The goal is to slow down the rate of inflation, but this can have a ripple effect across the economy. The central bank's rate influences commercial banks' rates, which affects everything from savings to mortgages. In some countries, variable-rate mortgages are common, and an increase in the central bank's rate can immediately reduce consumer spending. In others, fixed-rate mortgages are more prevalent, but higher rates still indirectly affect consumers by increasing the cost of new mortgages, which can lead to falling house prices and reduced spending. Businesses also face higher borrowing costs, which can limit investment and economic activity. Central banks must carefully balance the need to control inflation with the potential negative impacts on the economy, as raising rates too quickly can lead to recession. The Federal Reserve, for example, once raised rates to 19% to curb inflation, causing significant economic hardship. Central banks aim to maintain a steady inflation rate around 2%, which is seen as beneficial for a healthy economy. However, prolonged high inflation can lead to a wage-price spiral, as increased prices necessitate higher wages, which in turn push up business costs and prices. Central bankers must set expectations for inflation control and use interest rate adjustments as a tool to manage economic stability, despite the inherent challenges and delays in seeing the full effects of their decisions.

Takeaways

📈 **Central Banks' Role in Inflation**: When central banks raise interest rates, it's a significant move aimed at controlling inflation by making borrowing more expensive.
💹 **Economic Impact**: Rising interest rates can affect the entire economy, potentially leading to reduced consumer confidence, fewer jobs, lower wages, and falling stock prices.
🚨 **Risk of Recession**: If interest rates are increased too rapidly, it could push economies into recession, highlighting the delicate balance central banks must maintain.
💡 **Basics of Interest Rates**: Interest rates are the extra amount paid by borrowers to lenders, which can be beneficial for savers when rates are high.
🏦 **Central Bank Functions**: Central banks influence commercial banks' rates and act as a bank for banks, affecting the economy through the interest they pay on reserves.
💰 **Inflation Control**: Central banks use interest rates as a tool to hit an inflation target, typically around 2%, to ensure economic stability.
🏠 **Mortgage Rates and Spending**: Higher interest rates can immediately affect those with variable-rate mortgages, reducing their disposable income and potentially curbing spending.
📉 **Housing Market Effects**: In places with many fixed-rate mortgages, higher interest rates can lead to falling house prices, which indirectly affects consumer spending.
🛠️ **Business Investment**: Rising interest rates make borrowing more costly for businesses, potentially leading to less investment and slower economic activity.
⏱️ **Lag in Rate Effects**: There's a delay in the impact of interest rate changes, which can take up to two years, complicating central banks' decision-making.
🔮 **Predicting the Future**: Central banks must predict future economic conditions to set appropriate interest rates, a challenging task with no certainty.

Q & A

Why do central banks raise interest rates?
-Central banks raise interest rates primarily to control inflation, which is the rate at which the general price level of goods and services is rising. By increasing the cost of borrowing, they aim to slow down spending and investment, which in turn can help to reduce inflation.
What is the impact of rising interest rates on the economy?
-Rising interest rates can lead to higher borrowing costs, which may reduce consumer spending and business investment. This can result in lower economic activity, potentially leading to fewer jobs, lower wages, and falling stock prices. If rates rise too quickly, it could even push the economy into recession.
How do central banks influence commercial interest rates?
-Central banks influence commercial interest rates by setting the rate at which commercial banks can borrow from them. When the central bank rate increases, commercial banks may raise their own lending rates to maintain profitability, which in turn affects the cost of borrowing for consumers and businesses.
What is the role of reserves in the banking system?
-Reserves are the cash that commercial banks keep on hand or deposit with the central bank. Banks lend excess reserves to each other at an interest rate, and they can also earn interest on reserves they deposit with the central bank. The central bank's interest rate on these reserves can influence the rates banks charge each other and their customers.
Why is it important for central banks to hit an inflation target?
-Hitting an inflation target, typically around 2%, is important because it helps to maintain the stability of the currency and the economy. Moderate inflation can stimulate economic growth, but if inflation becomes too high, it can erode purchasing power, lead to increased production costs, and create an upward spiral of wages and prices.
How do variable-rate mortgages respond to changes in central bank interest rates?
-Variable-rate mortgages have interest rates that are directly linked to the central bank's interest rate. When the central bank raises its rate, the interest rate on these mortgages typically increases as well, which means that homeowners will have less disposable income to spend on other things, potentially reducing overall spending and inflation.
What are the indirect effects of rising interest rates on fixed-rate mortgages?
-While the monthly payments on fixed-rate mortgages are not directly affected by changes in the central bank's interest rate, the cost of new mortgages will increase, which can lead to falling house prices. This can make homeowners feel poorer, potentially leading them to spend less, which can indirectly contribute to lower inflation.
How do businesses respond to rising interest rates?
-Businesses may find it more expensive to borrow money for investment when interest rates rise. This can lead to reduced economic activity, as businesses might cut back on expansion plans, which could result in fewer job creations and lower wages.
What are the challenges central banks face when setting interest rates?
-Central banks face the challenge of predicting future economic conditions and the potential for inflation. They must decide how much to raise interest rates without causing undue harm to the economy. There is also a delay, or lag, in the effect of interest rate changes, which can take up to two years to fully impact the economy.
Why is it difficult for central banks to control inflation without causing a recession?
-Controlling inflation without causing a recession is difficult because the tools available, such as raising interest rates, can slow down the economy too much. Striking the right balance requires careful judgment and foresight, as overcorrecting can lead to widespread economic pain and a downturn.
What is the rationale behind using interest rates as a tool for controlling inflation?
-The rationale is that by making borrowing more expensive, central banks can reduce spending and investment, which can help to cool down an overheating economy and bring inflation under control. While this approach can be painful in the short term, the goal is to achieve long-term economic stability with low and steady inflation.
How do central banks set expectations for inflation?
-Central banks set expectations for inflation by demonstrating credibility and commitment to maintaining low and stable inflation. By consistently acting to keep inflation at target levels, they aim to build trust with the public and businesses, which can reduce the need for frequent and drastic adjustments in interest rates.

Outlines

00:00

📈 Central Banks' Interest Rate Hikes: Impacts and Rationale

The paragraph explains the significant role central banks play in controlling inflation through interest rate adjustments. When central banks raise interest rates, it increases the cost of borrowing, which can affect the entire economy, potentially leading to decreased consumer confidence, job losses, lower wages, and falling stock prices. The central bank's primary goal is to manage inflation, aiming for a target rate, often around 2%. The mechanism involves commercial banks earning more on their reserves, which may lead them to increase their own lending rates. This can influence consumers, particularly those with variable-rate mortgages, to spend less, thereby curbing inflation. The central bank's tool of interest rate adjustments is powerful but must be used judiciously to avoid causing a recession.

05:02

📉 The Consequences and Precautions of High Interest Rates

This paragraph delves into the broader economic implications of rising interest rates. It highlights the historical example of the Federal Reserve increasing rates to 19% in 1981, which, while effective in curbing inflation, caused substantial economic hardship. The paragraph emphasizes the complexity of managing inflation without hindering economic activity and the potential for an upward spiral of wages and prices if inflation remains unchecked. It also discusses the challenges faced by central banks in setting inflation expectations and the difficulty in predicting the effects of interest rate changes, which can take up to two years to manifest fully. Despite the potential for economic slowdown, central banks view the control of inflation as paramount for long-term economic health.

Mindmap

Keywords

💡Interest Rates

Interest rates are the percentage at which banks lend money to each other and to customers. In the context of the video, central banks use interest rates as a tool to control inflation. When interest rates are raised, borrowing money becomes more expensive, which can slow down spending and investment, thereby helping to control inflation. An example from the script is when it mentions that 'Rising interest rates will make the cost of borrowing go up.'

💡Inflation

Inflation refers to the general increase in prices of goods and services over time. It is a key concern for central banks because if left unchecked, it can erode purchasing power and lead to an unstable economy. The video discusses how central banks aim for an inflation target of 2%, and use interest rates to achieve this. An example is the mention of 'They’re trying to control inflation—how fast prices rise for everyone.'

💡Central Bank

A central bank is the main financial authority of a country, responsible for monetary policy and regulation of the economy. It is often referred to as a 'bank for banks' because it also provides services to commercial banks. The video emphasizes the role of central banks in setting the benchmark interest rate that influences all other rates in the economy. The script illustrates this with 'A central bank is like a bank for banks.'

💡Commercial Banks

Commercial banks are financial institutions that provide a range of services to the public and businesses, including accepting deposits, providing loans, and offering various financial products. In the video, it is mentioned that commercial banks have reserves and lend these to each other at an interest rate, which is influenced by the central bank's rate. An example from the script is 'Commercial banks have these things called reserves, so that’s a bit like their cash on hand.'

💡Reserves

In the context of banking, reserves refer to the cash or liquid assets that banks are required to hold and that are not available for lending. The video explains that commercial banks can earn interest on their reserves when they deposit them at the central bank. This is significant because it influences the interest rates commercial banks charge for loans. The script states, 'Commercial banks have these things called reserves, so that’s a bit like their cash on hand.'

💡Variable-Rate Mortgage

A variable-rate mortgage is a type of mortgage where the interest rate fluctuates based on a benchmark rate, often set by a central bank. When central banks raise interest rates, the cost of these mortgages can increase significantly, affecting the disposable income of consumers. The video uses the example of Finland and Australia, where many people have variable-rate mortgages, to illustrate how changes in central bank rates directly impact consumers.

💡Fixed-Rate Mortgage

A fixed-rate mortgage is a mortgage where the interest rate is set for the entire term of the loan, providing protection against interest rate fluctuations. While those with fixed-rate mortgages are not directly affected by changes in central bank rates, the video suggests that they may still feel indirect impacts, such as a decrease in house prices due to higher borrowing costs for new buyers. The script mentions 'In countries, like America or Canada... a bigger share of mortgages are set at fixed rates.'

💡Consumer Confidence

Consumer confidence refers to the level of optimism that consumers have about the economy and their personal financial situation. The video explains that rising interest rates can lead to lower consumer confidence, as higher borrowing costs can reduce spending and potentially lead to job losses and wage stagnation. An example from the script is 'It can sink consumer confidence...result in fewer jobs and lower wages.'

💡Economic Activity

Economic activity refers to the various actions and tasks that are related to the production, distribution, and consumption of goods and services in an economy. The video discusses how higher interest rates can slow down economic activity by making borrowing more expensive for both consumers and businesses. This can lead to less spending, fewer jobs, and potentially a recession. The script states, 'When interest rates rise... then businesses will find it more expensive to borrow and invest. That generally means less economic activity.'

💡Recession

A recession is a period of negative economic growth that lasts for at least two consecutive quarters, typically characterized by high unemployment, low investment, falling incomes, and a decline in consumer spending. The video warns that if central banks raise interest rates too quickly or by too much, it can push an economy into recession. An example from the script is 'If they go too far too fast, it can tip economies into recession.'

💡Monetary Policy

Monetary policy refers to the actions taken by a central bank to influence economic activity by adjusting the money supply, interest rates, or other variables. The video emphasizes the use of interest rates as a powerful tool in monetary policy to control inflation. The script illustrates this with 'Interest rates are a really powerful tool that they have to do that.'

Highlights

Central banks raise interest rates to control inflation, which can have significant impacts on the economy.

Rising interest rates increase the cost of borrowing, which can affect consumer confidence and lead to economic downturns.

Central banks aim for an inflation target of 2%, using interest rates as a tool to achieve this goal.

When central banks raise interest rates, commercial banks may earn more on their reserves, influencing their lending practices.

Higher interest rates can lead to less spending by households, which in turn can help to lower inflation.

In countries with variable-rate mortgages, higher central bank interest rates directly affect consumers' spending power.

In contrast, fixed-rate mortgages in countries like the U.S. and Canada protect consumers from immediate rate hikes but have indirect effects on the housing market.

Rising interest rates make borrowing more expensive for businesses, potentially leading to less economic activity and job creation.

The Federal Reserve once raised interest rates to 19% to curb inflation, causing significant economic hardship.

Controlling inflation without causing a recession is a delicate balance for central banks.

Inflation that remains high for too long can lead to a wage-price spiral, further exacerbating economic issues.

Central bankers are concerned about setting expectations for inflation and maintaining credibility in their actions.

The delay in the effects of interest rate changes can make predicting and managing inflation challenging.

Central banks must anticipate future economic conditions when setting interest rates, which is inherently uncertain.

Raising interest rates is a blunt but necessary tool for central banks to control inflation and stabilize the economy in the long term.

The ultimate goal of raising interest rates is to achieve low and steady inflation for sustainable economic health.