Interest rates are on the rise all over the world. But what does all this mean?
Interest rates represent the cost of money, therefore increasing them represents a cost for those who suffer the effect of this increase. But how does this affect the economy and what is the function of these rates?
Usually an increase in interest rates occurs when there are variations in inflation, inflation which is currently increasing strongly on a global scale, especially in the Western world where the US and Europe are faced with the risks of an increase. prices due also (and not only) to a war conflict that began a few months ago.
Why is the interest rate so important and decisive for our economy? Let’s see it together in this article where we will address the topic and explain in the simplest and simplest way possible what the interest rate is for and what its increase entails in our economy.
The role of inflation
We first need to know the role of inflation in the economy. Inflation is the level of consumer prices, essentially measuring how much prices rise or fall within an economy. A change in inflation therefore indicates a change in prices and usually the data we see on inflation are data that refer to the period of one year (it is called "year over year" data) indicating the trend of inflation on an annual basis. For example, when we see a figure that is expressed in this way “inflation at 10%”, it means that the price level has risen by 10% compared to the previous year.
Why does inflation go up? Very simple, rising inflation is an indication of a healthy economy, of an economy where demand is greater than supply and which causes prices to rise, increasing investments and projecting higher future consumption. However, this is valid when inflation moves within what is called an inflation "target", that is an ideal number that tells us that the economy is healthy and in Europe and the USA this number is equal to 2%. At the moment, inflation is well above this number and certainly not because the economy is healthy, on the contrary, an imbalance has been created that is difficult to manage.
So, who regulates this inflation? Central banks have the role, in their work, of regulating inflation through liquidity management. Let’s explain this concept better: if the economy has a lot of money available (liquidity) and this money circulates, then probably the economy moves and inflation restarts due to the increase in demand due to the new liquidity available. For example, at a time when we are with 0% inflation, the central bank will inject liquidity into the economy to reactivate demand. To whom does this liquidity go? It certainly does not go directly into the pockets of citizens, but to the banks that have the task of distributing this liquidity through loans, mortgages, lines of credit, etc.
If the banks do not distribute this liquidity in the system, the economy will not restart, regardless of the actions and will of the central bank. In essence, the central bank seeks to regulate inflation by injecting liquidity into the system, liquidity that will then be handled by the banking system within the economy. Having explained these concepts, let’s go now to see what is happening currently.
Interest rates and the role of central banks
Over the past 10 years, we have seen especially in Europe inflation at or close to 0%. Based on the above, what will a central bank ever do? He made sure that the banks had more liquidity (money) available to reactivate the economy. How to regulate the injection of liquidity? Well, we finally got to talk about the famous interest rate.
The interest rate is the cost paid by banks for the liquidity they need, liquidity that can be invested in various ways including loans, mortgages, etc. When we talk about interest rates at 0%, it means that banks have liquidity at their disposal at very low cost, liquidity that will serve precisely the purposes mentioned above. But what if this liquidity were invested in the financial markets and then not injected into the financial system? Simple, inflation does not rise and liquidity remains high.
Always remember, that in the markets the chickens always come back to roost and the liquidity will always have its effect, that is to raise prices. Ten years later, after the pandemic and after the outbreak of the conflict on the doorstep of Europe, the effects of the nefarious increase in liquidity are being felt on the skin of the middle class that has hardly seen that liquidity.
The liquidity at low rates granted to the banks was drained into the financial markets, thus financing the large listed companies which, after the recent events that have shaken the world in the last two years, have seen prices of their shares to collapse leading banks to liquidate positions on the markets and collect as much as possible. In the meantime, that liquidity was not in the slightest contrast within the consumer economic system, or rather, not to the real extent. In practice, the "crumbs" of that liquidity have reached the middle class, all by means of financing for goods of all kinds and by means of mortgages and loans.
So in this moment, the liquidity granted at low cost to the large groups of the economy, the only ones to provide adequate guarantees to the banks, has led to a price increase on the supply side without there being a real request. The result was therefore an increase in inflation without demand. In fact, many have spoken in recent years of a “demand crisis” in Europe, the main reason for inflation which did not rise. Now interest rates, or the cost of money, are rising precisely because inflation has risen and we need to bring it down. To pay for all this is obviously the economic system and mainly the last agents of the system, that is the consumers.
Future prospects
Central banks have seen the sharp increase in inflation due, in addition to undrained liquidity into the system, also from the supply chain problems and the increase in raw material costs deriving from from the ongoing conflict. Now, the only way to decrease inflation is precisely to raise the cost of money to reduce consumption, demand and lower the price level, this time damaging the companies that will have to lower their prices if they want to continue their life cycle.
Unfortunately, this is impossible and many companies could not cope with these problems, with the drop in liquidity and there will probably also be some variation in the job market. This scenario could last until inflation returns to acceptable levels around 2%, which takes time to happen. In the meantime, the increase in interest rates leads to a increase in the cost of loans and variable rate mortgages leading to a decrease in consumption and a decline in the real estate market, a direct consequence of the increase in costs for buy a property.
Basically, as confirmed by the ECB in the last press conference, the economic situation has only one direction, that of a slowdown. Right now, money has a high cost (price) on the market, so being able to save now could be a winner in the near future.
Original article published on Money.it Italy 2022-11-01 08:57:00.
Original title: Tassi di interesse alti, quali conseguenze per l’economia?
