Central banks raise interest rates to control rising prices - or inflation. When interest rates go up, economic activity slows, and unemployment often rises. Higher interest rates increase the cost of borrowing and encourage people to save more. While mortgage payments go up, savers gain. By raising interest rates, people spend less, which helps to push inflation down.
Therefore, if a central bank feels inflation is rising too quickly, it may try to control it by raising the base rate and pushing up interest rates.
As interest rates rise higher, the currency of the specific country strengthens on the foreign exchange markets, and that helps to reduce the price of imported goods.
Decisions, Decisions: When do Central Banks decide to act?
As the Governor of the Bank of England (BoE) Andrew Bailey has mentioned, deciding when to act and how much further to raise interest rates is a delicate balancing act. The BoE must tread a “narrow path” between taming high inflation and supporting the economy.
The reason for saying this is that if a Central Bank raises rates too far, too fast, will further unsettle the fragile economic recovery and tip the country into a recession.
Central Banks raising interest rates to curb inflation
At the moment, central banks around the world are pushing for the sharpest rise in interest rates in decades in response to soaring inflation. With living costs across advanced economies rising at the fastest rate per year since the 1980s, the US Federal Reserve (Fed), Bank of England (BoE) and European Central Bank (ECB) are taking aggressive action to ease inflationary pressures.
Reasons that inflation has risen dramatically
- The impact of the Covid pandemic
- Supply chain disruption
- Worker shortages
- Russia’s war in Ukraine driving up energy prices.
Inflation across the OECD group of wealthy nations has reached 9.2% which is the highest since 1988. Britain has the highest rate in the G7 group of rich countries with inflation hitting 9% in April, the highest since 1982.
Central banks have mandates from their national governments to target low and stable inflation, typically of around 2%, while also considering the health of the economy and outlook for jobs.
When central banks aggressively raise rates to control inflation, they hope to show how committed they are to bring inflation back to their target. They want to prevent expectations that higher inflation will become embedded as workers would start demanding higher pay or companies would keep putting up their prices.
How higher interest rates affect you?
When a central bank raises interest rates, high street lenders pass these increases on to consumer and commercial borrowers and savers which can result in higher mortgage costs.
If you have a mortgage with standard variable rates, you will see the difference. With those on fixed-rate mortgages, the higher costs will become apparent when you come to the end of your term. For example, analysts at Hargreaves Lansdown estimated that, when the Bank raised interest rates in May by 0.25 percentage points to 1%, mortgage payments would have gone up by over £40 per month.
If you are renting, buy-to-let landlords could pass on higher borrowing costs to you.
What are the dangers of higher interest rates?
Economic growth could stall if there is weak consumer demand. With living costs already hitting consumers’ spending power, this could worsen the risk of recession.
Britain’s economy is forecast to slow to a halt next year, with the country expected to fall to the bottom of the OECD’s growth league table, just above Russia.
With the current volatility and concerns about an economic slowdown, contacting a currency specialist will allow you to safeguard your business and finances by planning ahead. If you are a business transferring funds overseas, get in touch with Universal Partners FX and their dedicated team to discuss the latest market movements ahead of your currency exchange. Universal Partners FX can provide invaluable help on efficient risk management and tailored solutions to your business’ transfer needs.