FTA Vantage Point: Interest Rates  

How do higher interest rates impact the economy?

  • To discover the different ways interest rates impact the economy
  • To understand the different stages of the economic cycle
  • To discover how interest rate movements impact unemployment
How do higher interest rates impact the economy?

The dilemma facing policymakers when confronted with excessively high inflation is that, however they react, they will have to hurt some sector of the population.

Central to this is the Phillips curve, which calculates that as unemployment falls, inflation will rise, with the inverse also applying

This means that policymakers have, effectively, to choose between driving inflation down and unemployment up, or allowing inflation to linger above the 2 per cent target level, while unemployment falls. 

As the UK economy exited the pandemic restrictions, policymakers were initially happy to let the economy 'run hot' – that is, have inflation at above the 2 per cent target in order to enable the unemployment rate to fall.

Richard Woolnough, bond fund manager at M&G, says: "Central banks set interest rates and wider monetary policy in order to stimulate demand via low rates, or to increase saving via high rates.

"Altering the price of money changes the behaviour of individuals and industry. This is an imprecise science with the effect always approximate and the timing usually delayed – empirically around 18 months between the policy change and the lagged outcome to inflation, growth and employment.

"When exercising monetary powers the central bank will always have an idea of the direction of the outcome but, like investors, will often be surprised by the real world response.” 

He adds that economists have historically taken the view that interest rates need to be at around 5 per cent in order to achieve inflation of around 2 per cent.

Woolnough says that since the global financial crisis, the view in the UK has been that interest rates at a peak of 2 per cent would be enough to control inflation, but this may have changed.

The fund manager says: “Traditionally, one would look to rates being set at above inflation to discourage spending and increase saving; given a 2 per cent inflation target, this was generally achieved by setting rates around 5 per cent before the financial crisis.

"This time around, the working assumption is that the world is now different and so the market assumes that 2 per cent rates would be enough to get inflation back on track. This assumption can be challenged in a number of ways, particularly with regard to the current dynamics of the UK labour market.

"Before the financial crisis, the pool of excess labour in Europe was available to the UK. This has now been severely curtailed after Brexit. This means the vacancies-to-unemployed ratio is now more significant than it was in the past. The Bank of England has to develop a new understanding of the domestic labour market post Brexit. The current hot economy will be a challenge for monetary policy implementation for central banks, and the bond markets.” 

The typical economic cycle occurs in four stages as it exits recession, with recovery, expansion, downturn and recession.

Policymakers aim to cut rates and keep them low at the start of the cycle, in order to stimulate economic growth. As the economy moves through the recovery and into the expansion phase, inflation will be rising, and so central banks seek to put rates up in order to moderate this inflation.