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It is not known quite how quickly an interest rate rise or fall feeds through into the economy. This depends on a range of other factors: industrial structure, income levels, house prices, starting level of interest rates, level of debt among consumers, willingness of financial services organisations to pass on rate changes to consumers, and so on.
But we can be certain of the general effects of a rate rise:
- Money becomes more expensive.
- This means that the cost of borrowing rises. You would expect to see an increase in the rate of interest charged by financial service providers for short-term borrowing, such as bank overdrafts and credit card advances. Long-term borrowing such as for mortgages would also become more expensive.
This is designed to dampen down CPI inflation by cutting demand for borrowing. As a result, consumers should be discouraged from spending. In response, retailers and producers should be less likely to risk raising prices. So the impact on the price level of the basket of goods and services should be to lower its rate of increase.
- Savings become more attractive.
- If the rate of interest rises, then you would expect the rate paid to savers to rise as well. This should have the effect of making saving a more attractive option. If people put more of their income into savings accounts, then that money will not be immediately spent on goods and services. As a result, pressure on prices ought to be reduced, as retailers and producers will be less likely to risk raising their prices.
- The exchange rate rises.
- If the interest rate rises, then the UK becomes a more attractive home for speculators' money (this is also known as 'hot' money). 'Hot' money flows around the world's financial centres seeking the best rate of return. Very small differences in rates may account for large differences in the returns available for speculators. This is because of the very large sums of money involved.
A rise in UK interest rates makes this country a more attractive 'home' for 'hot' money. More money flowing into the UK compared to other financial centres leads to a rise in the UK's exchange rate. The UK's currency (known as 'sterling') will be worth more, as a result, in terms of other currencies.
The sterling to US dollar rate of exchange has risen significantly in recent weeks, driven by expectations of a rise in UK interest rates. £1 is worth more than $2 at present (May 2007). Goods priced in dollars become 'cheaper' to UK consumers, as a result. This means that the effective price of imports into the UK should fall. As the UK tends to import a great deal of its consumer products, then the impact of a higher exchange rate should be to ease the rate of rise of CPI inflation in the UK. The opposite effect will happen with UK exports; a stronger sterling exchange rate makes these more expensive to overseas customers.
Decisions taken inside this building impact on all levels of UK society. Copyright: Biz/ed team.
So, the Bank of England raises rates if it wants to cut consumer demand in the UK economy. It also knows that a stronger exchange rate (£ to $ or £ to Euro, for instance) means that the price of imported goods should fall. So even if consumer demand fails to respond as expected, the UK economy should see less pressure on consumer prices. The impact ought to be that CPI inflation should ease.
One final point on the impact of interest rate rises reflects the UK housing market. Here, prices have risen at a very fast pace in recent years. This has encouraged many home owners to re-mortgage, effectively increasing the amount they borrow against the value of their houses. They can do this safe in the knowledge (they think) that the value of their property will continue to rise. Higher interest rates encourage these individuals to think again about adding to their mortgages. They may also act to slow down the rate of increase of house prices.
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