Zoe Fiddes from easy-forex looks into the effects of interest rate changes on the financial markets
This week we have seen both the UK's central bank, the Bank of England (BoE), and the European Central Bank (ECB) opt to leave interest rates unchanged in the face of growing concern about the flagging eurozone economy. But what impact do interest rate changes have on financial markets and the economy?
Interest rate expectations are a big fundamental driver in the currency market. If the herd gets any sniff of an interest rate hike from any given central bank then you may see the currency in that bank's jurisdiction strengthen as it becomes a more attractive investment. The opposite happens when there are signs of an interest rate cut as traders look to offload their investment in that currency.
Interest rates are set by a country's central bank and they are primarily used to control consumer spending which, in turn, controls inflation. Inflation, the increase in the price of consumer goods, is healthy for an economy, however when this increases too much it means products can become too expensive for the likes of you and I.
A central bank, such as the Bank of England, usually increases interest rates with the aim of encouraging consumers to borrow less and hence spend less. As demand drops, this tends to lead to a decrease in prices. This process is known as tightening. In contrast, loosening is the process whereby a central bank cuts rates in order to encourage spending and, in turn, increase inflation. A rate cut often leads consumers to borrow more and spend more.
This also helps to explain why UK interest rates have been held so low at 0.5% for over two years by the BoE - they want us to spend. The theory is that if consumers are spending and money is going round the financial system, the UK's economic recovery will be quicker. The economy has been stagnant for some time which suggests this strategy is currently not working and may explain why the BoE has chosen to increase its programme of quantitative easing (QE) by £75bn.
QE, or 'printing money' as it is sometimes referred to, is the concept of injecting cash into the system so banks are willing to lend more money and it will subsequently be cheaper for companies to raise capital.
Ideally, this is meant to lead to economic growth and an increase in employment. It sounds like a fine plan in theory, however things may not run so seamlessly. We have already had one round of QE and further cash injections may erode the real value of our money, hence we could be faced with the prospect of higher inflation in an already inflated economy.
Hyperinflation is dangerous in the current climate because it could cause consumer goods to become unaffordable leading to stagnation. If QE is overdone, in its most extreme form, it could lead to economic depression.
The BoE committee says its decision to increase QE was motivated by worries of inflation falling below the target of 2% in the medium term. Given that UK inflation has been above 4.0% since January with the last reading at a 4.5% it is hard to understand where the committee are drawing this estimate from.
It suggests that there is a lot of confusion amongst the members over which way the strategy should be taken.
The UK's unemployment rate currently stands at 7.9% and there has been no real effort by the British government to reduce this.
I believe that the intentions of the QE programme should be directed more towards increasing employment by making it easier for small and growing businesses to borrow money.
It's these smaller businesses that have been hugely damaged throughout the economic downturn and I hope that this cash injection provides more opportunities for those that need it most.