Across the world, central banks are increasing interest rates in response to the growing threat of inflation. In the last three months, monetary policymakers have increased their key interest rates 60 times in many different countries.

The US Federal Reserve, for example, has increased its discount rate from 0.25% to 1% this year and the Bank of England has increased its base rate from 0.1% to 1 %. Markets expect US interest rates to be in a range of 2.75%-3.00% by the end of 2022 and to peak at 4% in 2024.

Whilst the absolute changes in interest rates look quite small, the relative change in rates is very significant. If US rates reach 4% in 2024 they will have increased by a factor of 16 in two years.

The tightening of monetary policy in so many countries represents a complete change in direction from the widespread loosening during the Covid19 pandemic. Indeed, interest rates have been at record lows since the financial crisis in 2008. Between 1971 and 2022 US interest rates averaged 5.44%, but since 2009 they have averaged less than 1%.

The change in monetary policy comes as the rate of inflation has increased dramatically over the last 18 months.  In early 2021 US inflation was at 1.8% and it had reached 8.3% in April 2022. Rising energy costs, supply chain problems in manufactured goods, and labour shortages have all contributed to exceptional cost-push pressures in most of the world’s economies.  

Chair of the US Federal Reserve, Jay Powell has said ‘the Federal Reserve needs to move expeditiously towards tighter monetary policy and be prepared to act even more aggressively if necessary to tackle excessive inflation.’

Next month the European Central Bank is set to increase interest rates for the first time since 2011. The Canadian, Australian, Polish, and Indian central banks are also expected to raise rates in the coming weeks.

When central banks increase interest rates the change in rates starts to filter through to the wider economy through the commercial banking system and the money markets. For example, the US mortgage rate on a 30-year loan has reached 5.27%, the highest since 2009. This increase in interest rates will have significant implications for US households who will have to pay more interest on their home loans.

Businesses are also going to face higher borrowing costs due to rising interest rates, which will increase their costs and make the investment in new capital more expensive. Governments will also need to pay more interest to service the national debt.

There will be some winners from the rise in global interest rates. The returns to savers will increase although the rise in savings rates is likely to be slow. With the average deposit rates for US savers at around 1% and with inflation at over 8% the real rate of interest looks a little disappointing.

Possible points for discussion with a class

1. How important is a central bank in determining interest rates in an economy?
2. Research the different rates of interest that exist in your economy.
3. Why do central banks increase interest rates to reduce inflation?
4. What are the implications of increasing interest rates on the wider economy of a country?