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Secrets behind interest rates

24 January 2007

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.

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