How do interest rates affect inflation?
the official Bank Rate
from the official Bank Rate to inflation
the effects on demand
how long do these effects take to work?
Monetary policy aims to influence the overall level of monetary
demand in the economy so that it grows broadly in line with
the economy's ability to produce goods and services. This stops
output rising too quickly or slowly. Interest rates are increased
to moderate demand and inflation and they are reduced to stimulate
demand. If rates are set too low, this may encourage the build-up
of inflationary pressure; if they are set too high, demand will
be lower than necessary to control inflation. How does this
work?
the official Bank Rate 
Monetary policy operates by influencing the price of money,
ie the cost of borrowing and the income from saving.
the MPC sets the interest rate for the Bank of England's own
financial market transactions
In the UK, the Monetary Policy Committee (MPC) sets an interest
rate for the Bank of England's own market transactions with
financial institutions - the rate at which the Bank will make
short-term loans to banks and other financial institutions.
This rate is known as the official Bank Rate.
from the official Bank Rate to inflation
Changes in the official Bank Rate then affect the whole range
of interest rates set by commercial banks, building societies
and other financial institutions for their own savers and
borrowers. It will influence interest rates charged for overdrafts
and mortgages, as well as savings accounts. A change in the
official Bank Rate will also tend to affect the price of financial
assets such as bonds and shares, and the exchange rate. These
changes in financial markets affect consumer and business
demand and in turn output. Changes in demand and output then
impact on the labour market - employment levels and wage costs
- which in turn influence producer and consumer prices.
the effects on demand
When interest rates are changed, demand can be affected in
various ways.
Spending and saving decisions
A change in the cost of borrowing affects spending decisions.
Interest rates will affect the attractiveness of spending today
relative to spending tomorrow. An increase in interest rates
will make saving more attractive and borrowing less so. This
will tend to reduce current spending, by both consumers and
firms.That includes spending by consumers in the shops and spending
by firms on new equipment, ie investment. Conversely, a reduction
in interest rates will tend to increase spending by consumers
and firms.
Cash flow
A change in interest rates will affect consumers' and firms'
cash flow, ie the amount of cash they have available. For savers,
a rise in interest rates will increase the money received from
interest-bearing bank and building society deposits. But it
will also mean higher interest payments for people and firms
with loans - debtors - who are being charged variable interest
rates (as opposed to fixed rates which do not change). These
include many households with mortgages on their homes. These
fluctuations in cash flow are likely to affect spending. Lower
interest rates will have the opposite effects on savers and
borrowers.
Asset prices
A change in interest rates affects the value of certain assets,
such as house and share prices. Higher interest rates increase
the return on savings in banks and building societies. This
might encourage savers to invest less of their money in alternatives,
such as property and company shares. Any fall in demand for
these assets is likely to reduce their prices. This reduces
the wealth of individuals holding these assets, which, in turn,
might influence their willingness to spend. Again, lower interest
rates have the opposite effect, ie they tend to increase asset
prices.
Exchange rates
A particular influence on prices comes through the exchange
rate. A rise in interest rates relative to those in other countries
will tend to result in an increase in the amount of funds flowing
into the UK, as investors are attracted to the higher sterling
rates of interest. This will tend to result in an appreciation
of the exchange rate against other currencies. In practice,
the exchange rate will be influenced both by expectations about
future interest rates and any unexpected changes in interest
rates. That is because if investors expect interest rates to
rise, they may increase the amount they invest in a currency
before interest rates actually rise. So there is never a simple
relationship between changes in interest rates and exchange
rates.
Other things being equal, an increase in the value of the pound
will reduce the price of imports and, because many imported
goods are included in the CPI, this will have a direct influence
on inflation. In addition, a higher pound will tend to reduce
the demand abroad for UK goods and services. Any fall in export
demand will, in turn, reduce output, as will any shift of domestic
spending to imported goods. A reduction in interest rates will
tend to have the opposite effect.
how long do these effects take to work?
Changes in the official Bank Rate take time to have
their full impact on the economy and inflation. All the factors
we have described have an impact on demand and, in turn, prices.
Some influences, such as those on the exchange rate, work
very quickly.
a change in the official Bank Rate takes around two years
to have its full impact on inflation
But it often takes time for changes in the official Bank Rate to affect the interest payments made by consumers or firms
- such as mortgage payments - or the income from savings accounts.
It is likely to take a further period of time before changes
in mortgage payments or income from savings lead to changes
in spending in the shops, and longer still for this spending
to work its way up through the supply chain to producers.
Changes in production, in turn, can lead to changes in employment
and wages and eventually to changes in prices.
We cannot know with any certainty the precise size or timing
of these influences. And the effects might vary depending on
factors such as the stage of the economic cycle - for example,
the impact of higher consumer demand on inflation just after
a recession will be different than that after several years
of growth.
interest rates have to be set based on what inflation might
be over the coming two years or so
This is because after a recession, when output has been falling,
there will be plenty of spare capacity in the economy - output
will be able to rise quite strongly without generating inflationary
pressure.
A change in the official Bank Rate may have some
instant effects - for example on consumers' confidence - which
may influence spending straight away. But, more generally,
a change in the official Bank Rate will take time to influence
consumers' and firms' behaviour and decisions. Overall, a
change in interest rates today will tend to have its full
effect on output over a period of about one year, and on inflation
over a period of about two years. This is, of course, a very
approximate guide.
In this sense, monetary policy has to look ahead. Interest
rates have to be set based on what inflation might be over the
coming two years, not what it is today - though that is a relevant
consideration. Policy-makers have to judge what the likely economic
developments will be over that period, in particular what the
rate of growth in demand will be relative to the growth in supply
(output). This is why the Monetary Policy Committee uses forecasts
of growth and inflation to help it decide on the right level
for interest rates. We don't expect you to produce forecasts
but we will explain more about their role in 'Policy Framework'
under the heading 'An
independent Bank of England' and in the Participants' Pack.
This section has provided a thumb-nail sketch of what is
referred to as the 'transmission mechanism' - the economic route-map
between changing interest rates and inflation. We tell you more
about the transmission mechanism in The
Economy section. We also describe the different parts of
the economy in this section. The data you will need to look
at to assess demand, output and price pressures in the economy
are in the Data section.
©2000-2009 Bank of England.
