The Bank of England’s decision to raise its policy rate at successive meetings for the first time since 2004 signals that the curtain may soon fall on more than a decade of rock-bottom interest rates.
With several further increases on the cards this year, we take a closer look at how changes in the policy rate affect the economy, how they may interact with the current high inflation, and the possible implications for financial markets.
How do interest rates affect the economy?
Economists have debated the details of how changes in the policy rate affect the economy (the so-called “transmission mechanism”) for decades, but there is broad agreement on the key channels.
The most significant is the effect of changes in the policy rate on other interest rates, like those that consumers receive on their savings and those that financial institutions charge for credit. These rates influence the behaviour of both consumers and companies. Increases in interest rates encourage saving (making it more rewarding) and discourage borrowing (making it more expensive).
This can slow demand across the economy, as consumers are incentivised to save rather than spend, and it becomes more costly for firms to fund investment. But the effects are typically felt more keenly by some than others. Individuals or firms that are major net borrowers are most likely to suffer. And among sectors, those where purchases are often funded with credit (like the housing and car markets) are likely to be first in the firing line.
The effects of policy rate increases can also take time to become apparent. Admittedly, some interest rates respond directly to changes in the policy rate. The Bank of England pays its policy rate to financial institutions on their reserves held at the central bank. And changes in the policy rate filter through rapidly to the rates at which financial institutions borrow and lend to one another. Certain rates, most notably those of “tracker” mortgages, are contractually tied to the policy rate, so also move in lockstep with it.
However, the pass-through to other interest rates may be slower and less complete. Changes in the policy rate alter the interest offered on current accounts with a lag of a few months, and in recent years typically less than one-for-one. Other factors entirely can have a greater bearing in some cases. Long-term lending rates depend not just on the policy rate today, but on expectations of how far it will rise or fall in future. Lending rates are also driven by changes in the perceived riskiness of borrowers, or constraints on lenders. This may help explain why average credit card and overdraft rates in the UK rose during 2020 as the pandemic struck, despite the Bank of England cutting its policy rate.
Meanwhile, changes in the policy rate can also affect the economy through three other channels.
First, they can affect confidence and expectations. The effect of a rate rise depends on the circumstances, and the central bank’s communication. In some instances, a rate increase may be a vote of confidence in the economy, boosting expectations for future growth. But more commonly, sharp increases in the policy rate may be interpreted as evidence that the central bank is prepared to sacrifice economic growth in pursuit of its inflation objective. Households and firms alike may think twice about major spending if they perceive that the growth outlook has weakened.