How does raising interest rates control inflation?

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 To read more of our coverage on interest rates, click the link And don’t forget to subscribe