Prices are rising, and the central bank does the one thing it can: it raises interest rates. It is worth knowing exactly what that reaches, and what it cannot.
Bank rate, December 20210.1%
Bank rate, August 20235.25%
The Bank of England raised its rate from 0.1% to 5.25% between December 2021 and August 2023. What is the FIRST thing a rate rise changes?
Yes.The rate is the price of borrowed money, and that is the only thing the bank sets directly. Everything else it hopes for has to travel through that.
Not quite.Backwards. Dearer borrowing is meant to cool spending, and cooler spending gives employers less reason to raise pay.
Not quite.Prices are the last link in the chain, a year or more away, and even then they slow rather than fall. The rate reaches them only through people spending less.
Put the chain in order: from the rate rise to slower inflation.
Yes.Four links, and the bank holds only the first. The other three are millions of people deciding to spend less, which is why it takes a year or more and why it hurts on the way.
An illustrative market. Set how much people want to buy, and how much there is to buy.
Price level (100 = normal)114
Amount actually sold70
Low · ShortDemand low, supply short. Prices sit at 114 and 70 units are sold.
Price level (100 = normal)80
Amount actually sold80
Low · NormalDemand low, supply normal. Prices sit at 80 and 80 units are sold.
Price level (100 = normal)62
Amount actually sold80
Low · PlentifulDemand low, supply plentiful. Prices sit at 62 and 80 units are sold.
Price level (100 = normal)143
Amount actually sold70
Medium · ShortDemand medium, supply short. Prices sit at 143 and 70 units are sold.
Price level (100 = normal)100
Amount actually sold100
Medium · NormalDemand medium, supply normal. Prices sit at 100 and 100 units are sold.
Price level (100 = normal)77
Amount actually sold100
Medium · PlentifulDemand medium, supply plentiful. Prices sit at 77 and 100 units are sold.
Price level (100 = normal)171
Amount actually sold70
High · ShortDemand high, supply short. Prices sit at 171 and 70 units are sold.
Price level (100 = normal)120
Amount actually sold100
High · NormalDemand high, supply normal. Prices sit at 120 and 100 units are sold.
Price level (100 = normal)92
Amount actually sold120
High · PlentifulDemand high, supply plentiful. Prices sit at 92 and 120 units are sold.
Price level (100 = normal)200
Amount actually sold70
Very high · ShortDemand very high, supply short. Prices sit at 200 and 70 units are sold.
Price level (100 = normal)140
Amount actually sold100
Very high · NormalDemand very high, supply normal. Prices sit at 140 and 100 units are sold.
Price level (100 = normal)108
Amount actually sold130
Very high · PlentifulDemand very high, supply plentiful. Prices sit at 108 and 130 units are sold.
Supply is SHORT, after a bad harvest. What does cutting demand do to prices?
Yes.The price falls as demand falls, and the shelves are no fuller. A rate rise can only ever move the first control; it grows no wheat.
Not quite.Slide demand down with supply short and the price does fall. It is not that rates cannot move a shortage's price; it is what they cost to do it.
Not quite.Supply did not move. The only lever a central bank has is on the demand side, and pushing it does not put a single extra unit on the shelf.
Move both controls to see how they work against each other.
Four prices rising in the same year. Tap the one a rate rise can reach.
Tap the part of the figure that answers it.
Which rise is made of people borrowing?
Gas, after a pipeline is cut40%
Second-hand cars, after cheap loans flood in25%
Wheat, after a drought30%
Shipping, after a canal is blocked50%
Second-hand cars, after cheap loans flood in
Yes.This rise is made of borrowing. Make the loans dearer and the buyers thin out; the price follows. It is the one rise here that a rate can actually touch.
Gas, after a pipeline is cut
Not quite.The biggest driver of 2022's inflation, and nothing a rate can reach. Dearer mortgages do not reconnect a pipeline.
Wheat, after a drought
Not quite.A rate rise grows no wheat. It can make people buy less bread, which lowers the price by making them go without.
Shipping, after a canal is blocked
Not quite.The shortage is a canal. Cutting borrowing in one country does not clear it; it just means fewer people can afford what gets through.
The rate rises from 1% to 5%. Who pays more, who earns more, and who is untouched this year?
A family on a variable-rate mortgage
A saver with cash in the bank
A family on a mortgage fixed until 2029
A business living on its overdraft
A government about to borrow to cover this year's spending
A pensioner whose pension is a fixed monthly sum
Yes.A rate rise is a transfer as well as a brake: it moves money from borrowers to savers. Who it reaches first is whoever's borrowing re-prices soonest, and a fixed deal is a wall it hits later.
Pay rises asked for when people expect 2% inflation3%
Pay rises asked for when people expect 10% inflation11%
Illustrative.
The Bank announces a 2% target and repeats it at every chance. If the rate is the tool, why does the announcing matter?
Yes.A price is set for next year, on a guess about next year. If everyone's guess is 2%, the guess comes true. The target is a way of steering the guess.
Not quite.Whatever the politics, the mechanism is in the pay talks: a target that is believed is a number people put in their demands.
Not quite.The rate reaches spending a year later. Expectations reach every price being set today, and a bank that everyone believes needs to move its rate less.
A rate rise works on demand: it makes borrowing dear so spending slows. It grows no wheat and opens no pipeline. A shortage is not demand.
Gas200%
Everything else8%
Rough price rises that year.
In 2022 wholesale gas prices roughly tripled after a pipeline was cut, and central banks raised rates hard. What could the rate rises do about the gas price?
Yes.The rate rise was aimed past the gas at the second bar, to stop the first bar's rise becoming everyone's pay rise and then everyone's price rise. That is the loop the next lesson is about.
Not quite.It did not touch the supply of gas either way. What it touched was borrowing, and the spending that runs on it.
Not quite.A rate opens no pipeline. Gas came down when supply was found and demand fell with the weather, and neither of those was a rate decision.
Lesson complete
A rate rise works on demand. A shortage is not demand.