Interest rates are hugely relevant to our everyday lives. They influence how much we pay for our mortgages, our loans and goods and services we use.
Interest rates are decided by Central Banks, whose role it is to closely monitor the amount of money in circulation and to calculate and track inflation. Inflation is tracked by calculating the average prices for a basket of around 700 different goods, which is done by Office of National Statistics (ONS) on a rolling basis. (Why inflation is not scary). Most of the Central Banks in Western (mature) economies have an inflation target of 2%, meaning that the average price of the ‘basket’ does not increase by more than 2% over a three-month period.
When does a price hike become inflation?
If we all want to buy or do something at the same time, demand goes up – like the rush to by fuel recently – and prices rise. Such price hikes could be temporary and be due to an unusual supply bottleneck, after which the prices resettle at a lower level.
Inflation occurs when higher prices become stubborn and tick-up steadily due to imbalances between demand and supply (such as housing). If price rises are sticky, central banks will – this is the theory – raise interest rates to ‘cool’ demand. This way, a central bank encourages people to save money and not spend it. Meaning demand will go down and hence prices too.
Simply put, when consumer prices go up, rates follow suit; when prices go down, rates go down and when prices are stable, rates remain the same. Imagine you have £200 spare cash and you want to decide to save it or spend it; if a bank pays you a 1% interest rate on this money, after 1 year, you will have a total of £202 in the bank. This is clearly unattractive; the low rate could deter you from saving the money and encourage you spend it instead and ‘consume’ it.
But oddly, even the shortest of glances at past inflation and interest rates, shows that the theoretical relationship between rates and inflation does not fly. Despite many different economic growth- and recession cycles over the last 12 years and inflation being between 0.6% and 3.8%, in the same period, interest rates have remained well below 1%. Actually rates today are 0.1% in the UK, 0.25% in the US and in Europe, interest rates are -0.50%, meaning you would pay the bank to please keep your money, instead of the other way around. At these rates, who would want to put money in a savings account?
So, who then really benefits from low rates?
First, the economy, which is all of us. If it is not worthwhile to save money, we spend it and economies thrive on that, after all mature economies heavily depend on consumer spending. Low interest rates allow households and businesses to borrow money cheaply, which drives consumption even higher. The economic theory that this should lead to price increases does not apply when – as many mature economies have done – manufacturing is outsourced to places where labour is cheaper and plentiful and hence increased demand is met with sufficient and low-cost supply.
But hang in a minute, what happens if businesses borrow money for near nothing and spend it elsewhere by building plants in low-cost countries? This means that (1) the low skilled labour force in many mature economies needs to find something else to do and that (2) possibly not enough investment stays or comes back into the outsourcing economy, creating a different set of problems – such as local unemployment, underinvestment in manufacturing, knowhow, and R&D. Governments are in fact picking up the bill for the quest of lower consumer prices and need to borrow more money to compensate for what is lost.
This is why governments really love low rates too. It means they can borrow vast sums at zero or negative rates to pay for this changing economy and those it leaves behind. There is also the constant increasing bill for healthcare (aging population) as well as for education to further build-up this newer and intellectually more demanding economy (Young Countries versus Old Countries: Why demographics matter).
Although for us, consumers, rates at 0.10% or 0.75% make little or no difference in our wallets directly, finance ministers in many countries will shudder at the thought of higher rates. The interest payments on the gigantic government debts will be much larger and future borrowing will be more expensive. And besides, higher borrowing costs for businesses may lead to price hikes, potentially stalling economic growth.
Who would want to be on the Board of any Central Bank now? Even the tiniest hike will spook businesses, stock markets and governments.
Have mature economies become addicted to cheap, aka free, money and are we now unable to change course? You decide.
Recommended links:
https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp
https://www.ons.gov.uk/economy/inflationandpriceindices
https://researchbriefings.files.parliament.uk/documents/SN05745/SN05745.pdf
https://www.ecb.europa.eu/euro/html/index.en.html
https://www.federalreserve.gov/monetarypolicy/openmarket.htm
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