In easy terms - the economy

[maryandtrees]

Can anyone help me understand how the Bank were able to increase interest rates today and makes things even harder than they have recently become? How does it affect inflation and then a recession. To me, an increase just stops people spending in the shops, bars and restaurants which will cost people jobs and pay etc. surely that can’t be good?

I don't understand it either op so I'm place marking as I know many will be able to explain it!

Very basic and I’m sure someone will explain it better but in theory when you can’t borrow money cheaply, there’s less money overall to be spent, which means there’s less demand for goods and services, which means the companies supplying said good and services wont be able raise prices, prices stop rising and thus inflation comes down.

I heard a brief explanation soundbite on the radio today. Like RandomQuest says, the BBC website says

'Raising rates makes it more expensive for consumers and businesses to borrow. The idea is that people start spending less, helping cool demand for goods and services and, in turn, slowing the pace of price rises'.

The Bank’s main remit is to control inflation. Inflation is the highest it’s been for years, so raising rates will help control price rises (inflation) because (as you say) people will spend less overall and have a greater incentive to save. This should in turn bring inflation in to control so the rate of price rises slows, which could help the cost of living crisis.

Bank rate is still extremely low compared to historical averages.

arguably though, rate rises won’t do much since inflation isn’t demand driven (economy is stagnating) and is caused by rising costs (fuel but also many other things). Therefore prices will continue to rise and those with tracker mortgages and any other loans/credit linked to inflation (index linked) will cost more. So we could move to a ‘stagflation’ situation (some would say we are there already), where there is low growth and high inflation.

Increasing interest rates reduces spending by making borrowing more expensive (and theoretically making saving more attractive, because your bank deposits are effectively loaned out and some of the profit is passed on to you).

This means that businesses, which rely on loans to grease their wheels because inflows come long after outflows, have greater expenses which are passed on to the consumer which lowers demand because you will, generally, sell fewer of a thing at a higher price.

If you can extrapolate further and makes guesses as to how the downstream impacts would be counterintuitive to the intended impacts, you're understanding why economics is a whole area of study.

To be fair there's a few economists saying that it won't work (or will have to get much worse before it works) because a big chunk of the price increases are supply side, ie the war is driving down supply of oil and grain.

The Uk is in a particularly bad position because Brexit has led to fewer people to work and this means those who are working can demand pay rises. Which sounds good on paper but the companies pass those extra costs on in price increases.

Coupled with a demand surge after lockdowns ended things we're looking tight. But then Russia invaded Ukraine and it got very ugly.

The national insurance hike hasn't helped either as companies are again passing it on in price rises.

I'm not sure what the answer is but pulling the hand break on the economy with interest rate rises will make things very painful for people struggling anyway, quite a while before it hits those with a lot of disposable income they can cut (& slow down inflation by reducing demand). It seems harsh to me.

An economy is made up of supply and demand. Generally when there is surplus supply things are cheap(er) as prices are driven down by competitors in the market. Currently there are global supply issues due to COVID, the war etc. This pushes the price of everything up as there’s limited supply but demand remains. One of the only tools the Banks have to temper demand is to increase interest rates thus making borrowing more expensive and therefore reduce demand, until a better state of equilibrium is reached. Whilst it sounds counter-intuitive , looking at nations that have uncontrolled inflation is a very bad situation. Money becomes almost worthless. A ‘perfect market’ where demand and supply are in perfect sync is only theoretical. The market adjusts itself all the time, and:or there is government intervention such as changing interest rates.

And to add OP:

if inflation isn’t controlled no one could afford to eat out anyway (theoretically) as the cost of goods is too high.

Interest rates per se don’t directly impact that, it’s targeted at capital assets such as mortgage rates and behaviour changes to encourage saving because of good returns on ISAs or not borrowing because credit interest rates are high, thus tempering demand.

Tempering demand does not mean no one goes out for dinner and all restaurants lose business - inflation will do in its own as everyone is priced out due to restricted supply.

They should have raised the rate sooner & higher imho.
I've been predicting an inflation tidal wave for 2 years.

Thought I was wrong after all but then Ukraine invasion happened. :(
Or maybe the covid recovery process would have baked the inflation in anyway.
The monetary policy people are still tiptoeing around, too slow.
It will get worse before it gets better.

@lljkk

Agreed. I think we can expect an increase every quarter for some time.