What Factors Affect Interest Rates?

Interest rates are the main tool for influencing economic activity and therefore affecting the inflation rate. In the UK, interest rates are set by the Bank of England Monetary Policy Committee MPC. In the US, interest rates are set by the federal Reserve.
In the UK, the MPC have been set an inflation target of CPI 2% +/- 1. Therefore, the most important factor affecting interest rates are the prospects for inflation.

  • Generally, a rise in inflation will cause interest rates to rise. A fall in inflation will enable lower interest rates.

Inflation Predictions.

The MPC produce an inflation report. This tries to predict inflation in the coming months and is important for determining interest rate movements. These are the kind of factors that can cause inflationary pressures to increase and therefore cause an increase in interest rates

  1. High economic growth. If growth is above the average sustainable growth rate, inflation is likely
  2. Depreciation of Exchange Rate. When exchange rate fall, imports become more expensive and domestic demand increases, causing both demand pull and cost push inflation
  3. Low Unemployment. When unemployment is very low it tends to cause rising wage inflation
  4. Rising house prices. This creates a wealth effect and therefore encourages spending.
  5. Price of Raw Materials. Rising prices of raw materials such as oil tend to cause cost push inflation.
  6. High levels of consumer confidence and low savings ratio

As well as inflation, the Bank of England may take into account economic growth. For example, if the UK experiences inflation and lower growth it is in a difficult position. But, if the economy does go into recession, it is likely they will worry about inflation less and try to keep interest rates low.