INTEREST RATE HIKE

WHAT IS INFLATION? HOW DOES IT AFFECT YOU?

Inflation is the rate at which prices rise.  A 2% inflation implies the general price level in April this year was 2% more than what it was in April last year.

WHY IS INFLATION BAD?

Apart from making things costly, it essentially erodes the basis on which one makes economic decisions.

WHAT IS RECESSION?

A recession requires an economy to contract for two consecutive quarters; a quarter is a period of three months.

WHAT IS CAUSING INFLATION?

The current inflationary spike is due to supply constraints –due to rising costs of food and fuel and this food inflation spike is linked to external factors –war in Europe

BUT HOW WILL RAISING THE INTEREST RATE REDUCE FOOD OR FUEL PRICES?

Central bank knows they cannot bring down food and fuel prices by forcing banks to charge a higher interest rate as the cause of food shock emanating from external sources

THEN WHY ARE CENTRAL BANKS RAISING INTEREST RATES?

Inflation expectations refer to people’s expectations of what the inflation rate will be in future. And they matter because these expectations are what determine people’s economic behaviour.

As such policymakers try to gauge what is happening to inflation expectations

SO HOW DOES RAISING THE INTEREST RATE CONTAIN INFLATION EXPECTATIONS?

Households tend to look at a recent food and fuel prices which are salient items in the average consumption basket and they form their opinion  about what inflation would be in the future

If households believe that inflation go up and stay up, they are in effect saying that it is better to prepare for that difficult situation

When a central bank raises the interest rate, while it may not be able to increase the supply of food and fuel, it does dampen the demand for these goods. For instance, dismayed by higher interest rates, many may postpone buying a new car, thus reducing the demand for fuel

BY disincentivising borrowing a central bank reduces borrowing-led demand. This does two things, it reduces inflation by bringing down demand and two it gives time for the supply to catch up with the demand