why this could be the last increase for a while
- Written by Edward Thomas Jones, Lecturer in Economics / Director of the Institute of European Finance, Bangor University
The Bank of England[1] has increased its benchmark interest rate to 4.5% – the seventh[2] rise since May 2022, when the base rate was just 1%. It is now at the highest level since 2008.
The European Central Bank (ECB[3]) also increased its benchmark rate to 3.25%[4] at its latest meeting in early May and is now nearing a high not seen since 2001[5]. A few days before, the US Federal Reserve[6] increased its rate from 5% to 5.25%, the highest level since mid-2007 and its 10th consecutive increase[7] in just over a year.
Both central banks are nearing the end of their rate-tightening cycles[8] as price pressures fall from a peak and the world anticipates a looming credit crisis.
Read more: Small businesses seek to avoid possible credit crunch as Federal Reserve raises rates once more[9]
But plans could change depending on how the economy fares. And whether we can expect the same from the Bank of England could depend more on the fragility of the banking system than the need to continue to tame inflation.
The UK’s new 4.5% base rate may seem high[10], but it’s actually quite low compared to the 1980s[11] and 1990s[12]. During these decades, the rate peaked at 16% and 13.88% respectively, but was always higher than 5%. These high rates reflected a similar battle with high inflation[13] by the bank as it is dealing with today.
Low base rate today versus 1980s and 1990s:
Three effects of central bank decisions
Even without such drastic rate changes, such monetary policy decisions affect the wider economy and inflation in three main ways. Economists call these transmission channels.
The most obvious of the three is the interest rate channel[27] because the changes in a central bank’s rates affect other interest rates such as mortgages. Higher rates will translate into higher repayments and less cash to spend on other things. Less spending means that businesses will be reluctant to increase their prices, which should lower inflation.
Interest rates also affect the real economy and inflation through the credit channel[28]. It covers lending to both businesses and people. This can be seen through the availability of bank loans, as well as business balance sheets and risk taking.
When interest rates rise, the risk that some borrowers cannot safely repay their debts may increase so much that a bank will not lend any more money to them[29]. These borrowers are then forced to stop spending or investing. This helps reduce inflation because less demand for products or services encourages companies to cut prices.
Changes in interest rates also affect firms’ balance sheets[30]. An increase in interest rates lowers the value of things a company owns such as a building[31]. In a higher rate environment, the property will be worth less, which matters if a business wants to use it as collateral on a loan for further investment in the business.
The effects of rate decisions on risk taking[32] is thought to operate in two ways. First, low interest rates boost asset (and collateral) values. This, along with the belief that an increase in asset values will last for a long time, leads both borrowers and banks to accept higher risks. Second, low interest rates make riskier assets more attractive because investors must search for higher yields to make returns.
So, when interest rates are low, banks relax their lending rules, which can lead to an excessive increase in loan supply. This pumps more money into the financial system. Rate increases have the opposite effect.
Banking crisis fears
These effects can be seen recently via banking failures, most notably Silicon Valley Bank[33] and Credit Suisse[34]. While they happened for different reasons, both collapses exposed regulatory failures and poor risk management. Both were also triggered by tightening credit conditions, and by the increase in interest rates related to central bank rate hikes.
Read more: Silicon Valley Bank: how interest rates helped trigger its collapse and what central bankers should do next[35]
Such financial fragility[36] should be expected in any parts of the banking system that are badly managed, poorly regulated and more exposed to tight credit conditions. This means another banking crisis could happen, especially if central banks continue to tighten monetary policy.
The Bank of England takes all of this into account when deciding on the next move for interest rates. And so, if it has stopped raising rates for now, it’s not because inflation has been tamed but because the risk to the banking industry is too great at the moment.
References
- ^ Bank of England (www.bankofengland.co.uk)
- ^ seventh (www.bankofengland.co.uk)
- ^ ECB (www.ecb.europa.eu)
- ^ benchmark rate to 3.25% (www.ft.com)
- ^ since 2001 (money.cnn.com)
- ^ US Federal Reserve (www.federalreserve.gov)
- ^ 10th consecutive increase (www.nytimes.com)
- ^ rate-tightening cycles (www.frbsf.org)
- ^ Small businesses seek to avoid possible credit crunch as Federal Reserve raises rates once more (theconversation.com)
- ^ 4.5% base rate may seem high (www.ft.com)
- ^ 1980s (www.ft.com)
- ^ 1990s (www.bloomberg.com)
- ^ battle with high inflation (www.historyandpolicy.org)
- ^ Bank of England (www.bankofengland.co.uk)
- ^ target of 2% (www.cnbc.com)
- ^ official UK data (www.ons.gov.uk)
- ^ a “basket” of goods and services (www.ons.gov.uk)
- ^ Surging energy prices (www.theguardian.com)
- ^ Russia’s invasion of Ukraine (www.bbc.co.uk)
- ^ fastest increase in over 45 years (news.sky.com)
- ^ a blunt tool (www.chicagobooth.edu)
- ^ inflation during the 1970s (www.nber.org)
- ^ Paul Volcker (en.wikipedia.org)
- ^ slammed the brakes on the economy (www.bu.edu)
- ^ 4 million people lost their jobs (www.npr.org)
- ^ mark reinstein/Shutterstock (www.shutterstock.com)
- ^ interest rate channel (www.jstor.org)
- ^ credit channel (www.sciencedirect.com)
- ^ will not lend any more money to them (www.sciencedirect.com)
- ^ firms’ balance sheets (www.jstor.org)
- ^ such as a building (www.economist.com)
- ^ risk taking (onlinelibrary.wiley.com)
- ^ Silicon Valley Bank (www.theguardian.com)
- ^ Credit Suisse (www.cnbc.com)
- ^ Silicon Valley Bank: how interest rates helped trigger its collapse and what central bankers should do next (theconversation.com)
- ^ financial fragility (www.federalreservehistory.org)
