Why central banks are raising interest rates

After the US central bank announced its largest interest rate rise since 1994, the Bank of England has followed suit by pushing UK rates to the highest level in 13 years.

In the aftermath of America’s “bumper” 0.75% rise overnight, the Bank of England today increased rates from 1% to 1.25%, the fifth consecutive rise, said the BBC.

It noted that Brazil, Canada and Australia have also raised rates, and the European Central Bank has outlined plans to do so later this summer.

These global changes come after businesses and households have enjoyed years of low borrowing costs.

Why are interest rates going up?

Put simply, higher interest rates make borrowing more expensive and encourage people to save. This reduces how much people spend, helping to push inflation down, said the Bank of England.

Therefore, if the Bank feels inflation is rising too quickly, it may try to limit it by raising the base rate, pushing up interest rates. Warning that consumer prices could surpass 11% later this year, the Bank decided to move again today.

Additionally, rising interest rates often lead to a stronger currency on the foreign exchange markets, and that helps to reduce the price of imported goods. This, said The Guardian, may have been a “key consideration” for the Bank of England.

Finally, policy makers are often attracted to rate rises as they feel they send a message that they are taking inflation seriously.

What goes into decision making?

The approach requires a delicate balancing act because it is also feared that raising rates too far, too fast, will further derail the frail economic recovery and tip Britain into recession. China and Russia are currently cutting their rates with a similar thought in mind.

Andrew Bailey, the Bank’s governor, has warned that Threadneedle Street must tread a “narrow path” between responding to high inflation and weaker growth.

“Plenty of people” think that the Bank should “leave well alone” and allow the inflation squeeze to get on with the job of slowing the economy and, ultimately, “squeeze inflation out”, wrote David Smith in The Times. “High inflation, on this view, will be the instrument of its own demise,” he added.

Writing on The Conversation, Brian Blank, a finance scholar, said that inflation is so high in the US that bringing it down “may require the highest interest rates in decades”, which could “weaken the economy substantially”.

Therefore, he said, the US Federal Reserve is seeking a so-called “soft landing” which would slow inflation without causing a recession.