How do rising inflation rates help cap inflation? – Click on Liverpool

The global cost of living crisis shows no signs of easing anytime soon, with UK inflation peaking at 9.4% in June.

In the Western world as a whole, this figure is expected to double in the fall, as global markets are affected by a further increase in the energy price cap.

To combat this, central banks around the world have sought to steadily raise their base interest rates.

In the United Kingdom, the Bank of England (BoE) has launched five such hikes since December, with the key rate rising from 0.01% to 1.25% during this period. In the United States, the Federal Reserve introduced its own 0.75% interest rate hike, the main objective of these hikes being to fight inflation and bring it down.

But how does it work in theory and will it make the economic climate worse in the short term? Let’s find out!

Interest rates, inflation and their complex relationship

In theory, inflation and interest rates have what is called an “inverse” relationship. This means that these distinct macroeconomic factors tend to move in different directions from each other, although specific movements are impacted by a slight lag.

Thus, if interest rates remain low for an extended period, inflation will continue to rise. Conversely, maintaining higher interest rates for a longer period will lead to lower inflation, so recent hikes have been designed to gradually bring the inflation rate back towards the typical inflation target. the central bank by 2%.

Throughout the coronavirus pandemic and its associated lockdowns, interest rates have been driven down to historic lows.

The reason is simple; because the base rate refers to the rate at which banks and institutional lenders borrow money, which in turn has a direct impact on the cost of borrowing for individuals, households and businesses.

During the shutdowns, governments and financial institutions have been borrowing at an unprecedented rate, to provide tax support to affected businesses and to introduce initiatives such as the furlough scheme for those whose jobs have been affected.

As a result, central banks moved to drastically cut their base rates to cap widespread borrowing costs, ensuring that governments and people affected by the lockdown could access the help and support they needed in times of crisis.

In the UK, the base rate has been reduced to an all-time low of 0.01%, and the maintenance of this rate throughout the pandemic and various lockdowns has gradually caused inflation and the cost to rise. goods and services.

Throughout 2022, this trend has accelerated. Inflation, for example, exceeded 6% in March, before exceeding 7% the following month. It hit a 40-year high of 9.4% in June and is expected to peak above 12% when the energy price cap rises again in October.

This acceleration forced the central bank to react by gradually increasing the key rate, five consecutive increases having been initiated by the BoE since December.

So how does a rising base rate help curb inflation?

The question that remains, of course, is how can a base rate hike help curb inflation?

Well, a lot of that has to do with the underlying reason why these two macroeconomic factors have an inverse relationship with each other, and the status of the base interest rate as a key policy tool. Monetary Policy.

For example, having a low base rate actively encourages household businesses to spend rather than save and take advantage of low borrowing rates (and the fact that their money won’t earn much in a standard savings account) .

However, this trend reverses when interest rates rise, with five consecutive rises in the UK having dramatically increased the cost of borrowing and removed the incentive for parties to raise capital or spend money.

At the same time, we are incentivized to save as the savings rate increases, creating a more frugal outlook which subsequently leads to lower demand for goods and services.

In theory, this scenario caps prices and prevents them from rising further in the short term, while stores and merchants are then inclined to reduce the cost of goods over time in order to entice customers to buy from them.

This should lead to a gradual decline in prices and inflation over the longer term, although this strategy is not guaranteed to work given the scale of inflation and widespread global uncertainty.

The Final Word – Could the Economy Suffer in the Long Term?

Everyone has been feeling the pinch in the cost of living lately, even currency investors who deal in automated trading and forex software.

The economy was hardest hit in the second quarter, contracting 0.03% and raising fears that a technical recession could occur before the end of 2022.

The decision to continuously raise the policy rate has only exacerbated these fears, not least because the rising cost of borrowing could trigger a period of “stagnation” in which growth stagnates significantly and inflation remains well above the BoE’s 2% target (although it is starting to decline slightly).

This could continue indefinitely into 2022 and into the year ahead, especially with the scale of energy price hikes and wider geopolitical uncertainty creating an unprecedented challenge for households across the board. .

With this in mind, we believe that other measures may be needed to fight inflation over the long term, to recognize the particular challenges the economy will face in 2022.

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