Why does the bank of England raise interest rates to curb inflation?

Answer 1

Most people have debt and the 3.5% increase in interest rates over the last 18 months has increased the cost of debt by close to 24%. This means that we pay 24% more for the same amount we borrowed than we did 18 months ago. Before I look at how interest rate increases can help to manage the rate of inflation I think we first need to understand what inflation means. Contrary to what many people think the direction of costs is always upwards when one speaks of inflation. When inflation comes down it does not mean that prices have reduced but only means that the increase in prices of goods and services are less. Inflation is the measure of the percentage increase in the prices of goods and services. As an example, we may have paid R4 for a liter of milk a year ago and now pay R5. This means that milk inflation is 25% for the year. If we pay R5.5 for milk next year it means that milk inflation is 10%. Milk inflation has come down even though we pay 50 cents more for milk. It means that the rate at which the price of milk increased is slower. The official consumer inflation rate is reported in two figures namely the CPI and the CPIX. CPI is the Consumer Price Index and CPIX is the Consumer Price Index excluding interest rates. The August figure for these two measures where 6.8% and 6.3% respectively. The Reserve Bank has a target to keep inflation between 3 and 6% and since the present figures are above the top end of the target, action needs to be taken to bring inflation back into the range. One instrument which can be used to manage inflation is interest rates. How does this work? The typical economic cycle is about supply and demand. The more people chase the same product the more the pressure to increase prices and the more products are available for the same number of people the more the pressure to reduce prices or to at least keep them at the same level. As an example lets say there are 10 people in the country and each of them has money to buy bread. If there is one bakery and they produce only 5 loaves of bread it means these 10 people will compete to buy the 5 loaves. To get a loaf of bread they will be willing to pay more and hence the price increases. Let us turn this around let us say there are two bakeries and they produce 20 loaves of bread. Now you have a situation where the 10 people can get more bread than what they need and all of a sudden the bakeries will have to compete and may reduce their prices to get the people to buy their bread. Now this is obviously a very simplistic explanation of the inflation cycle. In real life it is about how much money is chasing the available goods in an economic system. Presently we have too much money chasing the available goods because people use too much debt to buy these goods and services. This places pressure on the suppliers of these goods and hence they can increase their prices. The use of debt is in a sense artificial because people are spending money which they don't have and effectively borrowing from the future.

The higher the prices of goods and services, the more we as employees want from our employers to be able to keep our standard of living. The problem is if our employers pay us more for our services without us producing a higher output than we did in the previous year we are placing more pressure on the system and the spiral of inflation increases which means we are not better off than we where before the increase. By increasing interest rates the reserve bank reduces the cash in the economy. People now pay more for debt which means there are less money chasing goods and services and therefore the pressure on the system is reduced which helps to reduce the rate at which prices increase (inflation). In our example the 10 people chasing the 5 loaves of bread pays more for their debt and hence have less money to buy bread with. The effect is that the pressure reduces and the bakeries cannot increase their prices as easily. There are many arguments for and against the use of interest rates as a tool to manage inflation. The fact is however that managing inflation is critical for any economies success and growth because inflation erodes economic value and in effect negates what is achieved with economic growth. For the academics out there do not crucify me for this simplistic explanation I am only trying to explain the principle. In truth we know that the concept of inflation and the strategies to manage it is very complex as are the number of factors influencing inflation. I trust that this will help to put the concept in perspective. We as a nation have to ensure that inflation does not get out of hand and the best way for us to contribute to this objective is by not spending money we don't have and improving our productivity, this way we deserve above inflation increases because we offer our employers more.