The main interest rate (base rate) is set by the Bank of England / Federal Reserve. If the Central Bank is worried that inflation is likely to increase, then they may decide to increase interest rates to reduce demand and reduce the rate of economic growth.
Usually, if the Central bank increase base rates it will lead to higher commercial rates too.
Higher interest rates have various economic effects:
- Increases the cost of borrowing. Interest payments on credit cards and loans are more expensive. Therefore this discourages people from borrowing and saving. People who already have loans will have less disposable income because they spend more on interest payments. Therefore other areas of consumption will fall.
- Increase in mortgage interest payments. Related to the first point is the fact that interest payments on variable mortgages will increase. This will have a big impact on consumer spending. This is because a 0. 5% increase in interest rates can increase the cost of a £100,000 mortgage by £60 per month. This is a significant impact on personal discretionary income.
- Increased incentive to save rather than spend. Higher interest rates make it more attractive to save in a deposit account because of the interest gained.
- Higher interest rates increase the value of currency (due to hot money flows. Investors are more likely to save in British banks if UK rates are higher than other countries) A stronger Pound makes UK exports less competitive – reducing exports and increasing imports. This has the effect of reducing aggregate demand in the economy.
- Rising interest rates affect both consumers and firms. Therefore the economy is likely to experience falls in consumption and investment.
- Government debt interest payments increase. The UK currently pays over £30bn a year on its own national debt. Higher interest rates increase the cost of government interest payments. This could lead to higher taxes in the future.
- Reduced confidence. Interest rates have an effect on consumer and business confidence. A rise in interest rates discourages investment; it makes firms and consumers less willing to take out risky investments and purchases.
Therefore, higher interest rates will tend to reduce consumer spending and investment. This will lead to a fall in Aggregate Demand (AD).
If we get lower AD, then it will tend to cause
- Lower economic growth (even negative growth – recession)
- Higher unemployment. If output falls, firms will produce less goods and therefore will demand less workers.
- Improvement in the current account. Higher rates will reduce spending on imports and the lower inflation will help improve the competitiveness of exports.
AD/AS diagram showing impact of interest rates on AD
Effect of higher interest rates
Evaluation of higher interest rates
- Higher interest rates affect people in different ways. The effect of higher interest rates does not affect each consumer equally. Those consumers with large mortgages (often first time buyers in the 20s and 30s) will be disproportionately affected by rising interest rates. For example, reducing inflation may require interest rates to rise to a level that cause real hardship to those with large mortgages. However, those with savings may actually be better off. This makes monetary policy less effective as a macro economic tool.
- Time lags. The effect of rising interest rates can often take up to 18 months to have an effect. For example, if you have an investment project 50% completed, you are likely to finish it off. However, the higher interest rates may discourage starting a new project in the next year.
- It depends upon other variables in the economy. At times, a rise in interest rates may have less impact on reducing the growth of consumer spending. For example, if house prices continue to rise very quickly, people may feel that there is a real incentive to keep spending despite the rise in interest rates.
- Real interest rate. It is worth bearing in mind that what is important is the real interest rate. The real interest rate is nominal interest rates minus inflation. Thus if interest rates rose from 5% to 6% but inflation rose from 2% to 5.5 %. This actually represents a cut in real interest rates from 3% (5-2) to 0.5% (6-5.5) Thus in this circumstance the rise in nominal interest rates actually represents expansionary monetary policy.
- It depends whether increases in the interest rate are passed onto consumers. Banks may decide to reduce their profit margins and keep commercial rates unchanged.
US interest rates
Increased interest rates 2004-06 had a major impact on US housing market. Higher mortgage costs led to a rise in mortgage defaults – exacerbated by number of sub-prime mortgages in housing bubble.
In this case higher interest rates were a significant factor for bursting the housing bubble and causing subsequent credit crunch.
See: Housing boom
Interest rates and recession
Rising interest rates can cause a recession. The UK has experienced two major recessions, caused by a sharp rise in interest rates.
In 1979/80, interest rates were increased to 17% as the new Conservative government tried to control inflation (they pursued a form of monetarism). In 1980 and 81, the UK went into recession, due to the high interest rates and appreciation in Sterling. (see Recession 1981)
In the late 1980s, the UK inflation rate grew close to 10%, causing the government to increase interest rates to 15%. This caused another recession of 1990/91.