Can someone explain interest rates to me

I thought that raising interest rates to try to slow or stop inflation was supposed to a result of too much money chasing too few goods, eg we all spend too much on tvs, cars, luxury type goods etc, prices go up, we have inflation.
However this time we are chasing prices of goods that are beyond our control, gas, petrol, food, so if you like it's not our fault !
So we have higher prices, we therefore still have to control inflation by putting up interest rates which in theory would curtail spending, but the gap between the money we have and the commodities we need to live on is widening day by day.
It's a peculiar inflation. we have the same money but we can't reach the level of prices which keep going up and up. Heating or eating is a very apt phrase.

 

Dear Mr Badger,
It;s a very good question. As someone who studied economics for five years (albeit mostly in the eighties), I'll try and answer and bear in mind there is always a delay between policy introduction/event and effect, usually around 6 to 18 months and that economists sometimes split an economy into parts. This is micro-econmics and the study of the economy has a whole is macro-economics
Historical perspective
The idea that you could control an economy by the supply of money in an economy (which could be set by the price -effectively interest rates as well as the issue of gov bonds and printing) rose to prominence in the 60s advocated by the Chicago school of economists, led by Milton freidman. Ted Heath bought into this but actually refused to raise interest rates (mortgage payers= tory voters he thought) and this poured fuel on the fire of the OPEC fuel crisis in the early 70s.
Prior to this, Economists followed the Phillips Curve. A belief that an economy was a trade off between growth and inflation. The 70s disproved this and western economies had zero growth and high inflation, coined as "stagflation"
Thatcher and Reagan bought into it in the early 80s when they squeezed money supply. They kept failing and invented more and more measures to keep measuring money supply but eventually succeeded. This kerbed inflation but also cut aggregate demand in the economy which caused a recession. They also believed that people could, on a micro-economic level price themselves into a job by taking lower wages. The barrier to this was the Unions, most powerful of which was the NUM who the tories believed had to go, hence the Ripley plan and the strike. The problem was that all of this was an experiment. It worked in so far as inflation fell. It didnt work because whilst, even if it could work on a micro level to pay people less, on a macro level, workers are also consumers and following this would reduce demand in an economy. The realisation of this, sent the Chicago school and its UK acolytes such as Patrick Mingford back to the drawing board

External pressure on interest rates
The biggest external pressure on interest rates is that of other economies and their interest rates as there is a vast amount of money internationally buying up Gov bonds (ie Gov debt) in return for interest at a certain rate, usually having some basis in strong economies (that won't default) on the base rate. The US upped its interest rates the day before we did, no coincidence
The financial crash
Around 2008 the world economy was effectively put on life support with near zero interest rates. This should not really be seen as a new normal, nice for borrowers whilst it lasted, but talk of an eventual rise to 3.5% would still be historically low. The quantative easing that followed (effectively the gov issuing bonds and releasing money to buy them, had limited effect because it was left to the banks to do what they wanted with the money and much of it went abroad. Low interest rates didnt particularly stimulate investment in UK businesses as big business took advantage of them and sweetheart deals to relocate to other EU countries with lower labour costs, eg Jaguar to Slovakia, Cadbury to Poland, Ford Transit to Turkey (helped by a soft ECB loan)
Many people think successive chancellors kept QE going for too long
Covid 19
Much of the population got paid for staying at home with nothing to spend their money on and many people saved largish sums. This distorted an economic balance called the marginal propensity to consume (MPC) and MPS to save. If you give someone on £15k a year an extra £1k chances are they will spend it all. Give someone on £150k an extra £1k chances are they will save/invest at least some of it. There are people out there since lockdown eased with money ready to spend and on big ticket items. Try and get a new bathroom fitted, fitters are booked up for months etc.
It also dislocated international supply chains. Try and buy a new car (mostly forget pre-lockdown type discounts either). Chips are in really short supply and are used in virtually everything (I was told my BMW had around 30- several of which actually work)
Perfect storm: lots of demand, lots of money supply and restricted supply of goods/materials = inflation
Ukraine war
We do in fact live in a sad world where one man's ego and distorted sense of history can cause so much misery
Economically, inflation had already started but this fanned the flames drastically. The Russian economy relies on natural mineral wealth for 40% of its wealth and is a major player in fossil fuels. Although the UK hardly buys much of this, we do compete on international markets and prices have been driven up by reduction in supply and speculative pricing. Ukraine produces things (quite a bit actually) which has been stopped, making a bad situation worse
Where we are now
People have cited a number of reasons why we now face rising inflation and what to do about it. Firstly, people on here have blamed Brexit. I can't see a mechanism for it making a significant contribution but people may have spotted something I haven't. Every other western economy is in the same boat.
Sunak is in an invidious position. (and Boris isnt much help- get the crayons out to explain this to him). He is going to have to do something about inflation and I can't help thinking we are the same sort of position as we were in the 70s with both the money supply and external material supply pressure. This caused "stagflation".
He has some headroom in that we have near full employment but this also has the potential to drive labour costs as workers demand pay rises. He would have to restrict the supply of money into the economy and risk recession to curb inflation and runs the risk of over egging it because it will take a while to slow the economy down. The Bank of England is supposedly independent but the manager is held accountable for inflation so perhaps not really. He can also tax us more (or not cancel planned increases)
Expect tax rises and government cuts as well as interest rises. Rate rises may work more quickly than in the past because many people are on variable rate mortgages or tracker ones (I have two so I'm not doing back flips) and it will dampen demand quickly. We also need the EU to stop buying oil and gas off Russia to bring the war to a quicker end but that would put our prices up too, but hopefully only for a bit
Are interest rate rises going to solve inflation? Short answer, not on their own in the short term. Could they in the medium term? The answer is possibly yes but at what cost? Are they part of a solution? Yes but we need other things as well to resolve themselves

 

Supposedly reduces demand therefore retailers can't keep raising prices etc. It's load of ballony if you ask me but then again I'm no economist...

 

That's a huge factor, higher rates increase the strength of the pound. One of the reasons, along with Brexit etc that the pound has been so weak of a while.

 

I don't think it's anything to do with Quantative Easing.

That argument suggests all the extra money created was shared around. It relies on us all getting more money, all having more to spend, all buying more, which would push up prices and give us inflation.

That is the opposite of what has happened because as well as QE we've had austerity. Severe and crippling austerity. Wages have been frozen for years moving into decades. We're not out buying new TVs, we're relying on food banks. We all have much less money, barely enough to get by. This isn't a sudden phenomenon, it's been a gradual decline since 2008.

If you create more money and give it to the masses it gets spent increasing everyone's standard of living. That didn't happen. In 2008 it was used to bail out the banks. It has since been used to underwrite the tax burden of big business. It has gone to the rich. It has gone to the few. It has increased the gap between the very rich and the rest quicker than ever before making it wider than ever before. And it hasn't been spent, it has simply increased fortunes.

Giving lots of money to a very small section of the population while the rest of us get much poorer cannot, imho, increase inflation.

 

Everyone is affected by infation, not everyone is affected directly by interest rates rising.

So if interest rates go up GENERALLY the working people are the only ones affected as elderly, unemployed, low income, students dont GENERALY have mortgages.

So for the majority it is better to have high interest rates than high inflation, unfortunately the working person loses both ways, fortunately for the elderly, low income and students they are better off if inflation is low. Cheaper gin, cigs and baby food.☺

 

And austerity was justified by an economic paper that showed that economies didn't grow when the debt to gdp ratio went above 90%. Unfortunately, an error the spreadsheet used in that paper meant that certain cells were missed out - and when they were added in, the opposite happened (economies still grew). So the justification for austerity was the most expensive Excel error in history...

https://www.theguardian.com/politics/2013/apr/18/uncovered-error-george-osborne-austerity

 

It was also a George Osborne ideology.

 

QE might have had some indirect impacts - what is has done is massively change the Global economy - by printing money not linked to economic activity it has led to an economy where people are chasing asset bubbles rather then traditional wealth creation schemes - like making stuff to sell or providing people with a service for money - anyone who thinks NFTs or crypto-currency aren't asset Ponzi schemes are simply following a faith-based type of economic religion. Needless to say this cannot be healthy! The other thing I would add is that it maybe hard to find a traditional economic reason for inflation while the actual reason is staring us in the face - greed. Lots of corporations using "covid" and the "war" and "Brexit" as a cover just to put up prices and make more money,

 

Bill Mitchell's view if the inflation is mainly due to supply issues the raising of interest rates -
'It is a very costly strategy.


What they are effectively saying (central bankers) is that even though there are supply constraints, they are prepared to reduce aggregate demand down to the reduced level of supply.


The question then is what happens when supply recovers as factories reopen, ships move around and so on?


Well then they will be left with a massive pool of jobless people, some of whom will have been forced to default on their mortgages and lose their houses as a consequence, some of whom will have committed suicide, not to mention the generation of workers leaving school who will face limited opportunities in the labour market to progress with.


A clusterf*xk!

http://bilbo.economicoutlook.net/blog/?p=50042

 

There's a risk of a recession too.