Mortgage Advice

UK Interest Rates and Importance of inflation

When setting interest rates, the primary objective of the MPC is to control inflation. The MPC have an inflation target of CPI 2% =/-1. This is why The Bank of England is concerned with rising inflation. It explains why interest rates may remain high, even if growth slows down.

Central Banks are concerned about rising inflation for the following reasons:

1. Uncertainty / Confusion

Higher inflation creates uncertainty about the future revenue and costs of firms. Therefore, firms become less willing to commit to investment decisions. This can dampen economic growth in the long run. Uncertainty can also extend to consumption and discourage consumer spending.

2. Domestic Goods Become less Competitive.

Higher inflation in the US, would make US exports less competitive. This would result in a fall in exports and a deteriorating balance of payments on the current account. If exports are less competitive it will put further downward pressure on the dollar, causing imports to be more expensive.

3.Inflationary growth is unsustainable.

High inflation is an indication that the economy is overheating. This means that the economy is growing above its long run trend rate and therefore is unsustainable. If growth is too fast it is likely to result in a recession - Boom and bust economic cycle. Generally the Fed wishes to avoid volatile economic growth. It is better to keep inflation low and growth sustainable.

4. Menu costs

When inflation is high firms will need to frequently change prices. This is time consuming and incurs an economic cost. However, this cost is less important given advances in technology.

5. Income redistribution

When inflation is high savers become worse off (unless their savings attract a higher interest than inflation). People on fixed incomes will also become worse off. Borrowers may benefit, because it becomes easier to pay back their debts.

6. Wage Price Spiral

This means when there is inflation, workers demand higher wage increases. This causes further inflation, therefore, in the future, workers demand higher wages. This is an example of how moderate inflation can easily get out of control.

If inflation rises above 2% there are several economic costs. The higher the inflation rate, the more serious the problems become.