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

Sometimes the timing or scope of the rate rises is wrong – that is, central banks either leave it too late to put rates up or they put them up excessively quickly.

In the case of the former, inflation gets out of control, and it may be accompanied by a credit bubble, which subsequently bursts and leads to a very major recession of the kind seen around 2007.

In the case of the latter, the rates go up when the economy is still only in the recovery, or early-stage expansion phase, and tip it into recession.

In 2011, the European Central Bank was the first developed market central bank to lift rates following the global financial crisis, a move most economists now regard as a mistake, as it precipitated the sovereign debt crisis. 

Central banks' attempt to calculate a rate of interest that enables both full employment and inflation to be at or near the 2 per cent target, and to move rates up or down, to manage the economy towards that target. This theoretical calculation is known as the neutral rate of interest. 

What is making central bankers' lives difficult right now, according to Silvia Dall’Angelo, senior economist at Federated Hermes, is the speed at which the global economy may be advancing through the four stages of the cycle. 

The recession happened rapidly, but so did the exit, and we are therefore now either in the recovery phase, or already in the expansion phase.

She says: “It is possible we are already in a mature phase of the recovery. In addition to the pandemic effects of recent years, we have had very unusual monetary policy, which is having a distorting effect. Central banks are aiming for a soft landing, and that would see the level of economic growth slow this year, as monetary policy tightens.” 

By increasing interest rates, central banks are aiming to slow both the growth in the supply of money, and in the velocity at which money moves through the economy. 

Money matters

Money is created when commercial banks issue loans based on the level of their deposits or the funding they can obtain in the debt markets. 

Banks tend to want to do this when the economy is in the later stages of the recovery phase, or in the expansion phase, as the renewed level of economic activity should mean loans are performing and customers' savings levels are high. 

The risk is that with both banks and consumers feeling optimistic as memories of the previous recession fade, they reduce their level of savings, and increase their level of borrowing.