Over the summer, the financial news has been cluttered with annual reports, unusual stock market movements, and interest rates. While the first two are significantly important, I will focus on the last today as its volatility has ripple effects affecting the entire economy.
Firstly, it is essential to cover interest rates and how they control the world around us. Interest rates represent the cost of borrowing money or the return of savings as your money sits in the bank. When one takes out alone, the interest rate shows the extra amount one will need to pay on top of the borrowed amount or the annual payments. The base rate is set by the central banking agencies of nations, such as the Federal Reserve or the Bank of England; this rate is then taken by the banks and passed on to the consumers, usually adding or dedicating a small percentage. In general, lower rates encourage borrowing and spending, boosting economic growth, while higher rates aim to curb inflation by making borrowing more expensive. Interest rates fluctuate based on inflation, financial conditions, and monetary policy, impacting consumer loans, mortgages, savings, and investments.
A brief history of interest rates is needed to aid their understanding. Interest rates have been a key part of economic activity for thousands of years. In Mesopotamia, around 2000 BCE, clay tablets recorded loans with interest rates as high as 20%. The practice of charging interest, known as usury, was common in ancient Greece and Rome, though it was often debated morally and philosophically. During the Middle Ages in Europe, the Catholic Church largely prohibited charging interest, viewing it as sinful. However, with the growth of trade and commerce in the Renaissance, lending at interest became more accepted and standardised, leading to the establishment of banks. In the modern era, interest rates have become formalised economic policy tools. Founded in 1694, the Bank of England was among the first to set interest rates to control the money supply and financial stability. In the 20th century, central banks worldwide, such as the FED in the United States, began using interest rates as a primary tool for managing inflation and economic growth. Interest rates have fluctuated vastly over time, influenced by wars, recessions, and booms. The high inflation of the 1970s led to extremely high rates, while the early 21st century has seen historically low rates following the 2008 financial crisis. However, the rates have risen significantly in recent years due to the tough economic conditions.
The UK target for interest rates is 2.0% as of June 2024, while the base rate was 5.00% as of last month when a 0.25% drop occurred. One would notice that the base rate right now is significantly higher than the target. This is due to several factors, including the aftermath of the pandemic, the ongoing conflicts and inflation. Inflation peaked in October 2022 when it reached 11.10%, the target between 2-3%. This led to the UK central bank having to slow the market so rapidly, hiking up interest rates in the hopes of getting the inflation down to ease the pressure on the average citizen. Since then, inflation has slowed down, and the market is struggling, specifically the real estate market, which relies heavily on interest rates. Due to this, the UK central bank had to drop the interest rate from 5.25% to 5% earlier this year, and many top bank reports estimate that they will be dropped further to prevent a recession and keep the market going. Similar events have occurred in Europe and the US. Major players in the financial world watch rates intensely due to their immense significance on the entire globe. Interest rates affect everyone, from bankers buying assets requiring loans to people getting a mortgage on their house.
The global nature of today’s economy means that the impact of interest rate changes is not confined to one country. What happens in the UK or the US echoes across borders, influencing global trade, investments, and economic sentiment. For instance, higher interest rates in major economies can lead to capital flight from emerging markets as investors seek safer, higher returns, potentially destabilizing those economies. Conversely, lower rates can spur investment and spending but also risk inflating asset bubbles or driving unsustainable debt levels.
In conclusion, interest rates are far more than just a number discussed in financial news; they are a fundamental force that underpins the entire economic system, with far-reaching consequences that touch every aspect of society. The recent volatility in interest rates, driven by a combination of COVID recovery, geopolitical tensions, and inflationary pressures, highlights their central role in economic management. As we look ahead, interest rates will continue to be a vital indicator of economic health. The ongoing adjustments by central banks in response to inflation and economic slowdowns are closely watched by financial markets, businesses, and consumers. Future rate cuts, as anticipated in the UK and potentially in other economies, aim to prevent a deeper recession and stimulate growth. Still, they must be addressed carefully to avoid raising inflation or creating new economic imbalances.
By Annika Bjerregaard
Great article Annika!