With the Bank of England raising interest rates for months in a row, we are now seeing higher rates than ever. Well, higher than since I have been borrowing anyway.
The question I often see is, ‘how does raising interest rates help tackle inflation?’
As it’s a very pertinent question right now, I thought I would try to explain the answer.
How interest rates help reduce inflation
Interest rates act as a tool for adjusting the “withdraw” and “deposit” rates in the economy.
When inflation is high, it means prices are rising rapidly and people need more money to buy things.
To control this situation, the central bank, the Bank of England, raises interest rates. Higher interest rates make borrowing money more expensive, and when borrowing is expensive, people tend to spend less on things like houses, cars, and other goods.
This decrease in spending slows down the economy’s growth, and it also reduces the demand for goods and services.
In theory.
Reduced demand for goods and services means that businesses don’t sell as much, and they might have to lower their prices to attract customers.
As a result, the overall level of prices (inflation) starts to stabilize or even come down.
So, by raising interest rates, the central bank is trying to control inflation and prevent it from getting out of hand.
When inflation is low or the economy is slow, the Bank of England might decide to lower interest rates.
Lower interest rates make borrowing cheaper, which encourages people to spend and businesses to invest and expand.
This increased spending boosts demand for goods and services, and as businesses sell more, they may raise prices to keep up with the demand.
As a result, the overall level of prices (inflation) starts to pick up.
So, interest rates play a vital role in controlling inflation by influencing how much people spend and borrow.
When inflation is high, interest rates rise to slow down the economy and prevent prices from rising too quickly.
When inflation is low or the economy needs a boost, interest rates are lowered to encourage spending and investment, which can lead to moderate price increases.
If inflation is driven be necessities, how are higher rates going to help?
That’s all fine and good if we were all going out and buying sports cars and designer bags. But most of us are not.
Inflation is being driven by essentials, high fuel prices, food and basic living.
So how does inflation help with that?
The answer is like the above unfortunately. The idea is to cause the general population enough hardship that we cut back on everything we buy.
This lowers demand, causes companies to halt rising prices and slows down inflation.
For example, if gas prices are high, we cut back and use less gas. The gas company needs, less, so buys less. The producer sells less, so has to reduce prices accordingly to make a sale.
This all works in theory. In a world where there isn’t a war going on that is directly impacting prices.
Interviews with various bankers and business leaders on the news all say much the same thing.
Inflation is driven by people buying things. Raising interest rates makes sure we don’t have as much to spend as we used to.
Even if that’s petrol for your car, gas for your heating or food for your dinner.
It sounds harsh, and it is. But that’s the reality of the situation we find ourselves in.
