The interest rate cycle is closely related to the economic or trade cycle. It is the idea that interest rates increase when economic growth inflation increase. When the economy slows down and inflation falls, interest rates are cut to try to boost demand and economic growth.
For example, if the economy is growing rapidly and inflation is increasing. The Central Bank may increase interest rates to reduce the rate of growth and keep inflation on target. Higher interest rates increase borrowing costs and lead to slower consumer spending and investment. This moderates the rate of economic growth and keeps inflation on target.
When growth falls, the Central Bank cut interest rates to boost demand and spending.
Therefore, the interest rate cycle is roughly related to economic growth. Low growth leads to low interest rates. Higher growth leads to higher interest rates.
Diagram of Interest Rates in the UK
Note the two periods of very high interest rates in 1980 (17%) and 1990 (15%) were followed by recessions.
On both occasions interest rates were increased to reduce inflationary pressure. For example, in the late 1980s, the economy was growing very rapidly (over 4% a year) However, this rate of growth was unsustainable and caused inflation. To reduce inflation, the government increased interest rates. The high interest rates led to a recession in 1991. (Lawson Boom of late 1980s) | (In 1990, interest rates were also increased to protect the value of the Pound Sterling in the Exchange Rate mechanism.)
When the UK left the ERM in 1992, the Government were able to cut interest rates; this was necessary because the economy was in a recession. Interest rates fell to 5% in 1995. Since 1995, average interest rates have been much lower.
Taylor Rule and Interest Rates
The Taylor rule is a rough guide to monetary policy. It suggests that if inflation rises 1%, interest rates should rise 1.5%
see: more on Taylor Rule
Interest Rate Cycle and Real Interest Rates
Another issue is the real interest rate (nominal interest rate – inflation). If inflation increases, higher interest rates mean that ‘real interest rates‘ remain positive.
The UK has often experienced ‘boom and bust‘ economic cycles. It was argued governments would often cut interest rates before an election to boost growth. But, this would cause inflation and after the election, interest rates would be raised. This led to the Bank of England being made independent and given the responsibility for setting interest rates.
Interest Rate Cycle under Bank of England
Between 1997 and 2007, UK interest rates were fairly steady, the interest rate cycle has been less volatile. This period was known as the great moderation. It seemed the Bank were able to keep inflation on target and there was less need for drastic interest rate changes
UK interest rates increase to 5.75% in the summer of 2007 before starting to be cut in November 2007. In March 2009, base rates reached 0.5%
Interest Rates and Liquidity Crisis
In 2008, the global credit crunch precipitated a serious balance sheet recession. GDP fell sharply. In response the Bank of England cut interest rates drastically to 0.5%. However, even this interest rate failed to boost demand and the economy remained stuck in recession. Therefore, there was a prolonged period of interest rates close to zero from March 2009. (liquidity trap)
This prolonged period of zero interest rates (0.5% is often considered ‘virtually’ zero) suggests an end (at least temporary) to the interest rate cycle.
This prolonged period of zero interest rates has led to negative real interest rates. (in 2011, CPI is over 5%, but interest rates are lower). This means savers are seeing a fall in the value of their savings.