Secrets behind interest rates

Last week the Bank of England caught the City by surprise by raising the Interest Rate by a quarter of a point. Not long ago, before Christmas, it also surprised the City by not increasing the interest rate.

This behaviour might be rooted on the “Expectations Theory”. According to this theory, people have some expectations about what somebody else is going to do, and they would act as if those expectations were going to be true. So perhaps the Bank of England was playing with the expectations in order to make them behave as if there were an increase in rates.

What is this behaviour?

Changing the interest rate in order to affect the economy is an idea developed by Milton Friedman. He observed that periods of speculation or situations where there is too much money in circulation lead to increase in prices, what we call Inflation. If the situation gets out of hand, it all can end up in unreal prices. A mix between people not being able to consume anymore because of high prices and a sudden selling frenzy of assets which people think overpriced can trigger a crash, which is followed by a crisis.

In order to avoid it, the Central Bank increases the interest rate. This, on one hand, makes credit more expensive, and people less willing to get them and therefore, less money will be available to keep prices rising.

On the other hand, those who have money will find more attractive keeping it in the bank to get higher interest, with the result, as well, of less pressure on rising prices.

Let’s suppose you expect the Central Bank will increase the Interest rate. You will hold your hand before asking for a credit (above all if rates are variable), or will keep the money just in case you need it in future, because it is better to keep yours than to pay the higher interest in some months. As a result of your expectation, there is less money changing hands. Exactly what the Bank wants to achieve by raising the interest, but without doing it.

Now, the economic data is saying that inflation nearly reached 3% in december, that property prices keep on growing, and growth is expected to be 3%, very high for a developed economy. Facing this data, the Bank could not waste any time and decided to increase the interest to “cool down” the economy.

The other aspect that must be considered when talking about interest rates is the currency exchange, but all the analyses seem to point that it was not relevant in these two decisions.

Milton Friedman

Milton Friedman died last Thursday 16th November 2007. He was awarded Nobel Prize of Economics 1976 and was one of the most important economists of the XX century. I just want to talk here about one single thing of his long list of innovative theories, the management of the interest rate by central banks.

The Economy has cycles. Economists love to use graphics, and line graphs with peaks and troughs are their favourites. Those graphics mean that the economy has good times, when the curve goes up, and bad times, which are the crisis. The task of the economics authorities is trying to make the cycle as flat as possible, that is, to cool down the good times and try to make the bad times less severe.

One of the ways is with taxes and public investment. The trick is that when the Economy is in recession, an injection of money in the form of infrastructures or subsidies keeps the Economy going. This was the theory that worked to help recover from the 1929 crisis, the post-war recovery in Europe and Japan, and was developed by John Maynard Keynes.

The other way is playing with the amount of money available in the Economy. This was one of Milton Friedman’s contributions to the theory of Economics, the Monetarism, and it is normally managed by the central banks.

One of the tools used by Monetarism is the Interest Rate. When the Economy is growing, the movement of money increases, and Inflation becomes a real problem, because people having money in their hands tend to compete for the same goods, and those increase the price, which is the explanation of Inflation. Increasing the Interest Rate makes credits more expensive, and saving more beneficial, so the total amount of money in the economy decreases and so does the risk of Inflation.

On the other side, in periods of crisis, when people has no money or tend to save because bad times are coming, a reduction of the Interest Rate makes borrowing money cheaper and so companies can make investments, people can buy goods and the Economy starts working again.

Obviously this is an oversimplified explanation, but it works, and Milton Friedman was the first to come with the idea.