Why do central banks seek to raise interest rates?

In an effort to combat inflation, banks are hiking interest rates, but this could hinder economic expansion.

As a result of rising inflation, central banks all over the world want to sharply raise interest rates.

As living costs rise at the fastest annual rate since the 1980s, the US Federal Reserve, the Bank of England, and the European Central Bank are all taking big steps to stop inflation.

Consumers and businesses both face risks when economic growth slows down. Rates go up because:

Inflation has gone up a lot in the past few months because of the Covid virus, problems in the supply chain, a lack of workers, and Russia's war in Ukraine.

At 9.2%, OECD inflation is the highest it has been since 1988. Inflation in Britain was measured by the consumer price index (CPI), which went over 9 percent in April. This was the highest rate since 1982.

Central banks are told by their governments to keep inflation low and stable, around 2%, while also keeping an eye on the economy and job market.

The Bank of England is going to raise its base rate again on Thursday. This will be the fifth time in a row.

On Wednesday, the US Federal Reserve raised interest rates by 0.75 points. In response to last month's 8.6% inflation in the US, it was the biggest rise since 1994.

The ECB plans to raise interest rates in July and September. This will happen after it stops buying bonds next month.

How does it lower prices?

Inflation is when the prices of a basket of goods and services go up every year. Prices go up when supply is low or when demand is higher than supply.

Higher rates make people less likely to borrow and more likely to save. When debt costs more, it could affect consumer demand, business investment, and employment plans. When demand is higher than supply, it can help slow down inflation.

On foreign exchange markets, rising interest rates also make currencies stronger. This lowers the price of imports and may be a top priority for the Bank of England. With the Fed's aggressive rate hikes, the dollar is at its highest level in 20 years, while the pound is at its lowest level since the Covid outbreak in March 2020.

"The Bank will keep an eye on sterling," said ING economist James Smith. When energy costs go up in dollars, it hurts more when the pound gets weaker.

Central banks like to send messages. Central banks try to stop inflation by raising interest rates quickly. This stops people from expecting inflation to be high all the time, which could make workers want bigger pay raises or push companies to keep raising prices.

What does it mean?

When the central bank raises interest rates, high street lenders pass those increases on to borrowers and savers. The interest rates on mortgages go up faster than the rates on deposits.

Borrowers with variable rates who watch the Bank's base rate are the first to notice a change. Most home loans have rates that don't change. You won't have to pay more until your term is over. This is why central banks think it will take time for higher rates to stop inflation.

Buy-to-let landlords may charge renters more if they have to pay more to borrow money.

When the Bank raised interest rates by 0.25 percentage points to 1% in May, Hargreaves Lansdown predicted that mortgage payments would go up by almost £40 per month.

Rising interest rates are expected to raise consumer debt servicing costs from £55 billion to £83 billion over the next two years.

Risks?

When consumer demand goes down, economic growth is at risk. This could make it more likely that the economy will go into a recession, which is already a risk because living costs are going up.

Andrew Bailey, the head of the Bank, says that Threadneedle Street must walk a "narrow path" between high inflation and slow growth. Some people think that, to avoid a recession, the Fed will lower interest rates next year.

Except for Russia, the British economy is expected to stop growing next year.

Concerns about financial stability go beyond economic growth and inflation.

Governments with risks?

Higher interest rates and the ECB's decision to stop buying bonds have made people worry that the Eurozone will fall apart. This is similar to what happened during the sovereign debt crisis in the mid-2000s.

After Italy and Greece's borrowing costs went up sharply, the central bank held an emergency meeting on Wednesday to calm people's fears. Investors were worried that cutting back on economic stimulus could put pressure on governments that already had a lot of debt.

The chief European economist at PGIM Fixed Income, Katharine Neiss, wonders if the euro area can handle interest rates higher than 0%.

Rising Fed rates and a stronger dollar could be very bad for developing countries that owe a lot of money in dollars.

Due to a political and economic crisis, Sri Lanka did not pay back its loans, and some people think Ghana and Pakistan could also have problems.