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  • When central banks raise interest rates, it's big news.

  • ... bank is judging that the only way they can try to pull down inflation is to carry on raising interest rates.

  • - We're gonna see rising rates... - ... rising interest rates that will make the cost of borrowing go up.

  • It can send ripples across the whole economy.

  • It can sink consumer confidence, result in fewer jobs and lower wages, and cause stock prices to fall.

  • If they go too far too fast, it can tip economies into recession.

  • So, why do central banks raise interest rates?

  • (The Essentials)

  • (For Sale) (Interest rates)

  • Let's start with the basics.

  • If you borrow money, you'll have to pay back a little extra to make it worthwhile for the lender.

  • Oh, I think we can make you this loan.

  • You have a good reputation.

  • We know you're reliable.

  • I'm glad you think so.

  • This is the interest rate.

  • So, if you are taking out a loan, you want the interest rate to be as low as possible so you don't have to pay that much back.

  • On the flip side, if you want to save money, then a high interest rate means you can earn more on your savings.

  • See it as a reward for leaving money in your account.

  • But the size of your reward depends on the circumstances.

  • There's no single interest rate in the economy.

  • You've got thousands of banks setting their own commercial rates.

  • That's all influenced, though, by the interest rate that the central bank sets.

  • A central bank is like a bank for banks; just like you and your savings account, banks also earn interest when they leave money with a central bank.

  • Commercial banks have these things called "reserves", so that's a bit like their cash on hand.

  • Commercial banks lend those excess reserves to each other at an interest rate.

  • And they also can deposit their excess reserves at the central bank.

  • And when they do that, they can earn an interest rate.

  • Ordinary people can't access the interest rate on the excess reserves, but it still affects them.

  • And that's the idea.

  • When central banks raise interest rates, they're trying to control inflationhow fast prices rise for everyone.

  • They were £1.29, now they're £1.39, and that's in the space of four weeks.

  • Central banks like the Fed or the Bank of England or the European Central Bank are all trying to hit an inflation target of 2%.

  • Interest rates are a really powerful tool that they have to do that.

  • If inflation is seen as too high, that's when banks raise interest rates.

  • The change spreads through the financial system and slows down the rate of inflation.

  • Here's how:

  • A rise in interest rates from a central bank means that a commercial bank will earn more on their reserves.

  • They might make more from keeping their money in a central bank than lending it out.

  • So, if they do lend it out, they'll raise their interest rates to make it worth their while.

  • How that affects consumers depends on the economy.

  • Take mortgages.

  • In places like Finland or Australia, lots of people have mortgages with variable interest rates.

  • If you've got a variable-rate mortgage where the interest rate that you pay is linked to the central bank's interest rate,

  • then higher interest rates mean that, essentially, immediately, the higher rate will translate into less cash to spend on other things.

  • Less spare cash means households will spend less, and less spending means businesses will be warier of raising prices.

  • This should lower inflation.

  • In other countries like America or Canada, a bigger share of mortgages are set at fixed rates.

  • People with fixed rates are protected against the direct effects of an interest rate rise, but will still feel an indirect impact.

  • Higher interest rates mean that mortgages will become more expensive.

  • If that is affecting all new buyers, then house prices will begin to fall.

  • And that will make everyone who owns a home feel poorer and, therefore, they might spend less.

  • Lower spending will translate into lower inflation.

  • And it's not just consumers who'll tighten the purse strings.

  • When interest rates rise, then businesses will find it more expensive to borrow and invest.

  • That generally means less economic activity; it might mean fewer jobs are created.

  • Fewer jobs and lower wages could mean less money for households, and consumer confidence might suffer, which also means less spending.

  • People are grappling with a decline in real wages, meaning their money buys less.

  • When interest rates rise, that will tend to slow down spending, investment, and, generally, depress economic activity.

  • A rule that will make businesses more reluctant to raise their prices, and that will tend to pull back inflation.

  • It sounds straightforward, right?

  • But the trick is judging how far to go.

  • In 1981, the Federal ReserveAmerica's Central Bankallowed interest rates to rise to a whopping 19%.

  • The move curbed inflation, but it led to widespread economic pain.

  • I regret to say that we're in the worst economic mess since the Great Depression.

  • It is very difficult to get inflation under control without severely denting economic activity.

  • In America, it's been over 70 years since they've managed to get inflation down from over 5% without causing a recession.

  • A little inflation is okayit keeps the economy moving at a sensible speed, but inflation staying high for too long is a problem.

  • Higher prices means employees will need higher wages, pushing up costs for businesses.

  • That could drive up prices further, potentially leading to an upward spiral of wages and prices.

  • Retail inflation India has surged to 7.8%.

  • The combination of tepid economic activity and high inflation poses serious challenges for [the] Indian economy going forward.

  • Central bankers are really concerned about setting expectations of inflation.

  • The idea is that if it can show that it is credible, that it will always act to get inflation back down to 2%,

  • then maybe it won't have to, you know, raise interest rates and then lower them in this kind of seesaw fashion.

  • Raising interest rates can slow an economy right down.

  • The trouble is: the brake pedal has a delay.

  • It can take as long as two years to see the full results from interest rate changes.

  • Central banks know this.

  • So, when they set interest rates, they're actually trying to read the road ahead.

  • But predicting the future isn't easy.

  • The problem is, it's difficult for the central bank to work out whether the inflation will fall back on its own.

  • And even when central banks do get it right, they might still cause a crash.

  • It may be a blunt instrument, but raising interest rates is still central banks' main tool for taming inflation.

  • Central bankers would say that "yes, raising interest rates can be painful; slowing down the economy is not fun. But it's worth it".

  • It's worth it to get low and steady inflation so that, in the long run, you don't have to think about it.

  • Thank you for watching.

  • To read more of our coverage on interest rates, click the link.

  • And don't forget to subscribe.

When central banks raise interest rates, it's big news.

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B1 interest inflation interest rate central central bank bank

How does raising interest rates control inflation? | The Economist

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    林宜悉 posted on 2022/07/04
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