For most people, interest rates are something you have to pay on a personal loan or a mortgage, or something you get paid from a savings account.
Yet, that is just the tip of the iceberg. These kinds of rates are ultimately guided by the base interest rates set by central banks, such as the Bank of England or US Federal Reserve.
And these base rates have a huge impact not just on personal finances, but stock and bond markets, pensions and the economy as a whole.
So – whoever you are – you can’t really afford to ignore interest rates and how they work. Because they will certainly not ignore you.
The key task of central banks is to control inflation, or price rises in goods and services, while also supporting economic growth. Therefore, changes to inflation have a number of key impacts on interest rates.
1. Why central banks target inflation
According to economic theory, the price of goods and services rises when demand for them outstrips supply.
In a (very) simplified example, if a grocer stocks 20 apples daily, and only has four regular customers, who each buy five apples every day, demand and supply are evenly matched.
Say that the grocer charges £1 an apple – they have no incentive to reduce the price, because all of their stock is purchased daily. They could increase the price, but then risk losing customers to a rival.
However, if they find more – say five or six – customers coming to the store who each want to buy four apples, then the demand for the apples is higher than the supply. This would encourage them to raise the price of each apple above £1 – inflation.
Obviously, in the real world, things are a lot more complicated. A huge amount of factors go into determining overall demand and supply for goods, and it becomes extremely difficult to accurately predict what overall inflation will be (central banks usually get it wrong). Yet the same principle applies.
If inflation becomes too high, then it becomes hard for consumers and businesses to plan their expenditure and keep up with price rises. It also destroys the value of cash savings and deposits. This puts the stability of the economy and financial system in jeopardy.
2. Why inflation becomes too high
A number of things can cause a significant rise in overall inflation.
It can arise when the supply of some kind of widely-demanded good becomes much tighter than demand.
This can include labour – when the unemployment rate is low, and labour markets tight, inflation rises as employers are pushed to pay out higher wages.
Or when there is a sudden change in the supply of an essentially natural resource like oil, this pushes prices up across the board as businesses try to pass on their increased costs to consumers.
Inflation can also be caused when the amount of money circulating in the economy outpaces the supply of goods available. Today, this is usually in the form of debt created by banks.
3. When inflation is high, interest rates usually rise
Given that central banks are tasked with controlling inflation, they normally seek to use their powers to do just that.
The main way they do this is through raising interest rates. This raises the cost of borrowing by retail banks from central banks. Retail banks then raise their own interest rates on their loans to account for this.
Higher interest rates on debt mean that businesses and consumers are less likely to borrow. As they have less money to spend, this effectively lowers the demand for goods and services.
This then lowers the incentive for businesses to raise prices, bringing down inflation.
4, When inflation is low, interest rates sometimes fall
The reverse situation also applies, but not quite in the same way.
Central banks are also tasked with supporting economic growth. When growth falls, they can stimulate growth by cutting interest rates, which lowers the cost of borrowing for businesses and consumers. This encourages them to spend, and increases overall demand.
Central banks target a low level of inflation – currently around 2%. When inflation falls beneath this level, this can be cause for concern, as it suggests the economy could be weakening or prices. Therefore, they sometimes cut rates if inflation is persistently under their target.
One example is the Bank of Japan, which until recently maintained negative interest rates to combat decades of low growth and falling prices.
5. Sometimes these rules don’t apply
There are many cases throughout history and in countries around the world – particularly outside the West – where central banks do not undertake the standard measures outlined above.
Some countries may allow inflation to grow to double digit percentages or even more. One recent example is Turkiye, which under the administration of president Erdogan has seen the annual rate of inflation rise to more than 40% in recent years.
This can be due to unique circumstances, such as war or another kind of sustained crisis like the coronavirus pandemic where the need to support economic growth outweighs concerns over inflation. Another reason is that high inflation and low interest rates can help governments pay off their sovereign debt.
It can also be due to political pressure, with governments favouring low unemployment and continued economic growth over other considerations such as inflation.
Robin has more than six years of experience as a financial journalist, most of which were spent at Citywire, and covers the latest developments in the investing, trading and currency transfer space. Outside of work, he enjoys reading literature and philosophy and playing the piano.
You can contact Robin at robin@goodmoneyguide.com
