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How does raising interest rates control inflation? - YouTube
Channel: The Economist
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when central banks raise interest rates
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it's big news bank is judging that the
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only way they can try to pull down
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inflation is to carry on raising
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interest rates we're going to see rising
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rates rising interest rates that will
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make the cost to borrowing go up it can
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send ripples across the whole economy
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it can sink consumer confidence result
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in fewer jobs and lower wages and cause
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stock prices to fall if they go too far
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too fast it can tip economies into
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recession
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so
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why do central banks raise interest
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rates
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[Music]
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let's start with the basics
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if you borrow money you'll have to pay
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back a little extra to make it
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worthwhile for the lender well i think
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we can make you this long you have a
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good reputation we know you're reliable
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i'm glad you think so
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this is the interest rate
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so if you are taking out a loan you want
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the interest rate to be as low as
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possible so you don't have to pay that
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much back
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on the flip side if you want to save
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money then a high interest rate means
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you can earn more on your savings
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see it as a reward for leaving money in
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your account but the size of your reward
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depends on the circumstances
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there's no single interest rate in the
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economy you've got thousands of banks
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setting their own commercial rates
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that's all influenced though by the
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interest rate that the central bank sets
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a central bank is like a bank for banks
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just like you and your savings account
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banks also earn interest when they leave
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money with a central bank
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commercial banks have these things
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called reserves so that's a bit like
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their cash on hand
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commercial banks lend those excess
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reserves to each other at an interest
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rate and they also can deposit their
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excess reserves at the central bank
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and when they do that they can earn an
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interest rate
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ordinary people can't access the
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interest rate on the excess reserves but
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it still affects them
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and that's the idea
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when central banks raise interest rates
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they're trying to control inflation how
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fast prices rise for everyone they were
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129 now they won 39 and last in the
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space of four weeks central banks like
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the fed or the bank of england or the
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european central bank are all trying to
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hit an inflation target of two percent
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interest rates are a really powerful
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tool that they have to do that
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if inflation is seen as too high
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that's when banks raise interest rates
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the change spreads through the financial
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system and slows down the rate of
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inflation
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here's how
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a rise in interest rates from a central
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bank means that a commercial bank will
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earn more on their reserves
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they might make more from keeping their
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money in a central bank then lending it
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out
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so if they do lend it out they'll raise
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their interest rates to make it worth
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their while
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how that affects consumers depends on
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the economy
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take mortgages
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in places like finland or australia
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lots of people have mortgages with
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variable interest rates
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if you've got a variable rate mortgage
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where the interest rate that you pay is
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linked to the central bank's interest
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rate then higher interest rates mean
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that essentially immediately the higher
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rate will translate into less cash to
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spend on other things
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less spare cash means households will
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spend less
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and less spending means businesses will
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be warier of raising prices this should
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lower inflation
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in other countries like america or
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canada a bigger share of mortgages are
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set at fixed rates
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people with fixed rates are protected
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against the direct effects of an
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interest rate rise
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but will still feel an indirect impact
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higher interest rates mean that
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mortgages will become more expensive
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if that is affecting all new buyers then
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house prices will begin to fall and that
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will make everyone who owns a home feel
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poorer and therefore they might spend
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less
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lower spending will translate into lower
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inflation
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and it's not just consumers who will
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tighten the purse strings
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when interest rates rise then businesses
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will find it more expensive to borrow
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and invest
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that generally means less economic
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activity it might mean fewer jobs are
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created
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fewer jobs and lower wages could mean
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less money for households and consumer
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confidence might suffer which also means
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less spending
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people are grappling with a decline in
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real wages meaning their money buys less
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when interest rates rise that will tend
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to slow down spending investment and
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generally depress economic activity
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overall that will make businesses more
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reluctant to raise their prices
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and that will tend to pull back
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inflation
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it sounds straightforward right
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but the trick is judging how far to go
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in 1981 the federal reserve america's
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central bank allowed interest rates to
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rise to a whopping 19
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the move curbed inflation but it led to
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widespread economic pain
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i regret to say
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that we're in the worst economic mess
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since the great depression
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it is very difficult to get inflation
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under control
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without severely denting economic
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activity in america it's been over 70
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years since they've managed to get
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inflation down from over five percent
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without causing a recession
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a little inflation is okay it keeps the
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economy moving at a sensible speed but
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inflation staying high for too long is a
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problem
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higher prices means employees will need
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higher wages pushing up costs for
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businesses that could drive up prices
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further potentially leading to an upward
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spiral of wages and prices
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retail inflation india has surged to 7.8
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percent the combination of step 8
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economic activity and high inflation
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poses serious challenges for indian
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economy going forward central bankers
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are really concerned about setting
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expectations of inflation the idea is
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that if it can show that it is credible
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that it will always act to get inflation
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back down to two percent then maybe it
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won't have to you know raise interest
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rates and then lower them in this kind
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of seesaw fashion
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raising interest rates can slow an
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economy right down the trouble is the
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brake pedal has a delay
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it can take as long as two years to see
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the full results from interest rate
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changes
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central banks know this
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so when they set interest rates they're
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actually trying to read the road ahead
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but predicting the future isn't easy
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the problem is it's difficult for the
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central bank to work out whether the
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inflation will fall back on its own and
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even when central banks do get it right
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they might still cause a crash
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it may be a blunt instrument
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but raising interest rates is still
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central bank's main tool for taming
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inflation
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central bankers would say that yes
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raising interest rates can be painful
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slowing down the economy is not fun
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but it's worth it it's worth it to get
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low and steady inflation so that in the
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long run you don't have to think about
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it
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thank you for watching to read more of
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our coverage on interest rates click the
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