Real Interest Rates

CPI RPI Inflation and Interest rates

This is an interesting graph showing the movements in UK Base interest rates and the two measures of inflation, CPI and RPI.

The official measure of inflation is CPI. The interesting thing is that in the boom years, real interest rates were reasonably high. For example, in January 2005, base rates are 4.5% and CPI inflation is just less than 2%. This means real interest rates were +2.5%.

Now, real interest rates are negative. In March 2009, Base rates were 0.5%, CPI inflation was 2.2%. This means a negative real interest rate of – 1.7%. In theory this should boost spending and investment, but, of course many other factors are at work.

For a student just starting to learn Economics, this may prove a little confusing. One of the first things you may learn is how a cut in interest rates, should boost spending, investment and economic growth. Ceteris Paribus, a cut in interest rates should lead to higher inflation. However, since base rates were cut in the autumn of 2008 from 5% to 0.5%, inflation has continued to fall.

This reflects the scale of the recession and how loose monetary policy has been insufficient to prevent the rapid decline in output and fall in inflation.

However, forward looking indicators such as purchasing surveys and manufacturing orders suggest that the  loose monetary policy (and depreciation, Q.E. and loose fiscal policy policy)  is starting to have an effect. Hopefully, these forward looking indicators will mature into a real economic recovery. When looking at how interest rates effect inflation and growth, always consider the time lag and how a cut in interest rates may take upto 18 months to effect real variables.