Yesterday, the Bank of England kept UK base Rates at 5.75%. Although they released no statement it is believed that they are still uncertain about future inflation prospects. They will probably say that it is too early to judge the impact of the financial crisis. Economists feel that the Bank is in rush to cut interest rates, despite several factors suggesing the interest cycle is about to turn

Factors Which will Influence Future Interest Rates

• House prices are starting to fall. The Halifax reported a 0.6% fall last month. Annual house price inflation is still in double figures. But, if this monthly fall is not a one off it will significantly change the state of the economy and make future inflation
• The Cost of loans is rising. Especially cost of loans to non - financial corporates. This is a result of increased risk associated with loans and the malfunctioning credit market.
• Slowdown in Consumer Spending. - Retailers have been reporting slower sales.
• Strong Pound and Euro - The Pound and Euro are strong against its main trading partners, although, it is not certain how much of a problem this is going to be.
• US slowdown - Will it spread to Europe and the UK?
• Will Cost Push inflation rise as a result of increased commodity prices?

• At the moment UK inflation is close to the Bank's CPI inflation target of 2%
• EU interest rates were also kept steady at 4%

Labels: interest rates

It is very well for economists to talk about the benefits of recessions - "creative destruction" but, recessions do create real personal hardships for individuals affected by unemployment, bankruptcy and falling incomes.

Problems of Recessions

Recessions don't necessarily weed out just the inefficient. Recessions can cause the bankruptcy of many good companies who just can't cope with the temporary downturn. This particularly applies to new companies.

Uncertainty

Recessions create uncertainty which discourages investment. People dislike the uncertainty of fluctuations in the business cycle. Moderate steady growth helps encourage investment.

Hysteresis.

This suggests that high periods of unemployment tend to lead to higher unemployment rates in the future. Basically, if people are unemployed it becomes more difficult to get work in the future. This is because they become demotivated e.t.c.

High Interest Rates do not affect people equally.

Higher interest rates may be needed to discourage excess borrowing and inflationary pressures. However, people often forget that interest rates are an imperfect mechanism. They do not affect consumers equally. For example, new homeowners with a large mortgage will be heavily affected by a small rise in interest rates. The older generation who have paid off their mortgage may actually welcome rising interest rates. This is because it increases the income from their savings.

• Benefits of High interest rates - Why recessions are not so bad after all
• Causes of Recessions
• Why Do recessions last a long time?
  

Labels: interest rates, recession

• Discuss the Effects of an Increase in Interest rates on UK Economy.

In the UK Interest rates are currently 5.25% (April 2007). Inflation is 3.1%. Therefore real interest rates are 2.15%

An increase in the base rate will lead to an increase in the general cost of borrowing, throughout the economy. Also higher interest rates increase the return on saving money in an interest bearing account.

Therefore consumers will be less willing to borrow, e.g. on credit cards and personal loans. Also, consumers with variable mortgages will have an increase in monthly payments, therefore, they will have a reduction in disposable income. This will cause a significant fall in consumer spending, because, in the UK many home owners have mortgage payments, which account for a high % of their income. (This is as a result of rising house prices)

Similarly, the increase in borrowing costs will also reduce business investment.

Therefore with a fall in consumption and investment there is likely to be a fall in Aggregate Demand, or more accurately, AD will increase at a slower rate.

Therefore higher interest rates tend to reduce the rate of economic growth and inflation.

However, the effect of a rise in interest rates depends on various factors.

1. Effect on Savings (income and substitution effect)

Higher interest rates encourage savings and therefore reduce consumption (substitution effect). However, higher interest rates also increase income, for those with high levels of savings(income effect). Therefore, some consumers may actually increase spending. For example, in Japan many firms are currently investing out of savings. Therefore, an increase in interest rates is unlikely to discourage investment. In the UK, levels of debt are high and the savings ratio low, therefore, rising interest rates will be more likely to reduce investment and consumer spending in the UK.

2. The State of the Economy.

If the economy is growing above the trend rate of economic growth and is close to full capacity, a rise in interest rates will have the effect of moderating growth and reduce inflation. However, it is unlikely to cause a recession because the rest of the economy is buoyant. In the UK growth is close to the long run trend rate. Inflation is also slightly above target (3.1%). Therefore, arguably a rise in interest rates will not cause a significant problem.

3. Depends on Consumer Confidence

The effect of a rise in interest rates is sometimes hard to predict. If consumer confidence is high then rising interest rates may not discourage spending; people may just be willing to pay more interest. However, at other times a rise in interest rates may adversely effect confidence; therefore, the effect will be much greater. E.g. In the UK, many are concerned about the booming housing market, they feel the boom could soon turn to bust. A rise in interest rates could be the catalyst to stop house prices rising. If house prices fell it would have a significant impact on reducing consumer spending.


4. Effects on Exchange Rate.

Higher interest rates cause hot money flows, because it is more attractive to save money in the UK. Therefore, this will cause an appreciation in the exchange rate. An appreciation will make exports more expensive and imports cheaper. Assuming demand for exports and imports is relatively elastic, then an appreciation will reduce the growth of AD and help reduce inflation. In the UK, the exchange rate has been strong during the past year. Some experts argue it is fundamentally overvalued. Therefore, a further appreciation in the exchange rate would definitely not be welcomed by the exporting sector.

5. Time Lag.

It is estimated interest rate changes can take upto 18 months to have its full effect. Therefore, an increase in interest rates now, may reduce growth in the future. However in the UK interest rates have been increased from a low of 3.5% in 2003. Therefore, previous interest rates will begin to have an accumulative effect.

See also:

• Evaluation of MPC in controlling inflation
• Effects of Rising interest rates in UK
  

Labels: interest rates, UK Monetary Policy

With an unexpected strong rise in consumer spending in February and January interest rates are likely to increase in the near future.

House prices also continue to rise also adding to inflationary pressure.

The MPC increase interest rates to reduce inflationary pressures in the economy. They seek to keep inflation within the governments target of 2% +/- 1. Inflation is currently 2.7% but rising consumer spending could increase the inflation rate.

The effects of rising interest rates in the economy are quite varied but mainly involve reducing the growth in consumer spending and hence reduce economic growth.

View: Effects of increasing interest rates in the economy

Labels: interest rates, UK Monetary Policy