Central banks, interest rates and inflation
Investments team
July 2022
Overview
Central banks are official banks that act as a lender to a country’s government and other banks. They will try to make sure there’s a stable banking system, issue money and adjust the cost of borrowing and lending (using interest rates).
Adjusting interest rates is done to help meet economic targets, such as trying to control rising prices (also called inflation). Interest rate changes have been in the limelight so far this year as several major central banks have increased interest rates as they try to reduce the pressure of rising prices.
What makes central bank rate-setters think that increasing rates will control inflation? In this article we look at some key features of the US and UK central banks and discuss just how rate rises are expected to work.
Aims
The US central bank is the Federal Reserve System (also known as the Federal Reserve and Fed). It was set up in 1913, to help give stability to US financial structures following a banking crisis in 1907. The Fed is designed to act as an unbiased organisation of government. Its Federal Open Market Committee (FOMC) sets interest rates and must meet at least four times a year, but for the past 40 years it has met eight times a year.
In the UK, the Bank of England started out as a private bank in the seventeenth century but was nationalised in 1946 because of its importance to the UK economy. It became independent of government in 1997 so that its decisions were not tied to party politics. Interest rates are set by the BoE’s Monetary Policy Committee (MPC). The MPC meets eight times each year.
Inflation targets
Many central banks follow the belief that a country’s growth requires stable prices over the long term. These banks focus policies on helping to guide inflation to fall within a certain range, or towards a particular target. The key tool for this is interest rate adjustments. If prices rise too much, then interest rates are usually increased to cool down inflation, while if inflation is below target, rate cuts can be started. As prices have gone through the roof in recent months, the Fed and BoE have both increased interest rates in response.
The Fed’s target is for an average 2% rate of annual price rises. However, prices have been above this target for a while, so the FOMC increased rates in March, May and June 2022. This was because the bank wants to push rates up until inflation falls back. Further hikes are currently expected. The danger for the FOMC is that if rate hikes are too severe, it could hurt the economy.
In the UK, the BoE also has a 2% inflation target, which it measures by looking at the annual change in the Consumer Prices Index, which pulls together the price changes of a basket of goods.
If inflation is above or below this target by more than one percentage point, then the bank must explain this difference to the government in a letter outlining the bank’s plan to get it back on track. In May, the annual price rises reached a 40-year high of 9.1%. Since December 2021, rates in the UK have been increased five times, with the most recent rise being in June.
The transmission mechanism
By making changes to their key interest rates, central banks influence demand and then prices via the ‘transmission mechanism’. This system is how the bank’s rate changes spread through the economy. In simple terms, the central bank’s key interest rate is used as a guide by other banks for the interest rates they charge each other, what they charge businesses and consumers, and what they will pay for deposits.
Following a rate rise, business loans and consumer loans become more expensive. In theory, this increase in interest costs leads to fewer projects and less spending, and so demand for goods and services is reduced. As demand falls, so do prices. This process of changing interest rates takes time to affect the broader economy.
Additionally, a rate move is likely to change the value of the domestic currency, compared with other currencies. This can alter foreign demand for domestic goods and services. Other assets could also see prices affected, including shares and houses. This in turn can impact opinions; if people feel poorer they are less likely to spend, which will feed through to demand.
What's next?
From here, it will be interesting to note how the banks will react if prices run much higher. Time will tell if the Fed and BoE can reduce price pressures and make sure the UK and US economies are not weakened too much by reduced consumer and business demand.