The global cost of living crisis shows no sign of abating any time soon, with inflation in the UK having peaked at 9.4% in June.
Throughout the western world, this is expected to reach double figures in the autumn, as the global markets are affected by yet another energy price cap increase.
To combat this, central banks across the globe have been looking to steadily increase their base interest rates.
In the UK, the Bank of England (BoE) has initiated five such hikes since December, with the base rate having increased from 0.01% to 1.25% during this time. In the US, the Federal Reserve has introduced its own base rate increase of 0.75%, with the main aim of these hikes being to combat inflation and drag it down.
But how does this work in theory, and will it make the economic climate worse in the short-term? Let’s find out!
Interest Rates, Inflation and Their Complex Relationship
In theory, inflation and interest rates have what is known as an ‘inverse’ relationship. This means that these distinct macroeconomic factors tend to move in different directions to one another, although precise movements are impacted by a slight lag.
So, if interest rates remain low for an extended period of time, inflation will continue to rise. Conversely, maintaining higher interest rates for a longer period will cause inflation to fall, so the recent hikes have been designed to gradually drag the rate of inflation back towards the typical central bank target of 2%.
Throughout the coronavirus pandemic and its associated lockdowns, interest rates have been lowered to historic lows.
The reason for this is simple; as the base rate refers to the rate at which banks and institutional lenders borrow cash, which in turn impacts directly on the cost of borrowing for individuals, households and businesses.
During the lockdowns, governments and financial institutions borrowed at an unprecedented rate, in order to provide fiscal support to affected businesses and introduce initiatives such as the furlough scheme for individuals whose employment was affected.
As a result, central banks moved to slash their base rates to cap the costs of widespread borrowing, ensuring that governments and those affected by the lockdown could access the help and support they needed during times of crisis.
In the UK, the base rate was cut to an historic low of 0.01%, and sustaining this throughout the course of pandemic and various lockdowns has gradually caused inflation and the cost of goods and services to rise.
Throughout 2022, this trend has accelerated. Inflation broke through 6% in March, for example, before rising beyond 7% the following month. It hit a 40-year high of 9.4% in June, and is forecast to peak above 12% when the energy price cap increases again in October.
This acceleration has forced the central bank to react by hiking the base rate incrementally, with five consecutive increases having been initiated by the BoE since December.
So, How Does a Rising Base Rate Help to Curb Inflation?
The question that remains, of course, is how can a rising base rate help to curb inflation?
Well, much lies with the underlying reason why these two macroeconomic factors have an inverse relationship with one another, and the status of the base interest rate as a key monetary policy tool.
For example, having a low base rate actively encourages households businesses to spend rather than save and cash in on low borrowing rates (and the fact that their money won’t deliver much of a return in a standard savings account).
This trend reverses when interest rates are increased, however, with five consecutive hikes in the UK having raised the cost of borrowing markedly and removed the incentive for parties to raise capital or spend money.
At the same time, we’re incentivised to save as the savings rate increases, creating a more frugal outlook that subsequently sees the demand for goods and services fall.
In theory, this scenario caps prices and stops them from rising further in the near-term, while shops and merchants are then inclined to reduce the cost of goods over time in order to incentivise customers to buy from them.
This should see prices and inflation fall gradually in the longer-term, although this strategy is not guaranteed to work given the extent of inflation and widespread global uncertainty.
The Last Word – Could the Economy Suffer in the Long-Term?
Everyone has felt the pinch of the cost of living of late, even currency investors who deal in forex automated trading and software.
The economy bore the brunt in Q2, contracting by 0.03% and raising concerns that a technical recession could ensue before the end of 2022.
The decision to hike the base rate continually has only served to heighten these fears, not least because the rising cost of borrowing could trigger a period of ‘stagnation’ during which growth stalls considerably and inflation remains well above the BoE’s target of 2% (even if it starts to fall slightly).
This could continue indefinitely through 2022 and into the New Year, especially with the extent of energy price hikes and wider geopolitical uncertainty creating an unprecedented challenge for households across the board.
With this in mind, we’d argue that other measures may be required to combat long-term inflation, in order to recognise the special challenges facing the economy in 2022.