How do interest rates affect the real economy?


The reversal of monetary policy will have a tangible impact on the real economy for consumers and businesses in these countries, and elsewhere, including countries whose economies are much more fragile.

The US Federal Reserve announced the most aggressive interest rate hike in nearly 30 years, raising the benchmark borrowing rate by 0.75 percentage points on Wednesday.

And the Bank of England was to raise its key rate on Thursday for the fifth consecutive time.

– Higher borrowing costs –

Higher central bank interest rates affect the cost of borrowing for banks, which then pass those costs on to businesses, consumers and even governments.

This means higher borrowing costs, like buying a house.

“Mortgage rates are already on the rise, and this should accelerate,” said Eric Dor, head of economic studies at IESEG School of Management in France.

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Higher borrowing costs eventually slow down borrowing and hence economic activity. This should eventually slow down inflation, which is the goal of central banks in raising interest rates.

Those who have to borrow face higher costs, but those who have fixed rates on long-term loans (as is the case with mortgages in many countries) should benefit as the value of repayments has decreased in real terms.

– Savers celebrate –

Those with savings also stand to gain from rising interest rates. However, most savings rates still offer rates considerably lower than the rate of inflation.

– Monetary values ​​and trade –

Higher rates affect the value of currencies.

The dollar has appreciated against the euro, as the US Federal Reserve has already started to raise interest rates, while the European Central Bank will not start to do so until July.

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The strong dollar will make imports cheaper for US consumers, but will likely hurt US exports which will be more expensive for foreign buyers. This could dampen employment.

It is the opposite for the euro zone and Great Britain, which have seen the value of their currency weaken against the dollar. Imports are more expensive, especially oil, which is priced in dollars. Exports are stimulated because they are cheaper in dollars. An export boom could help support employment.

– Emerging Issues –

US interest rates also affect the borrowing rates of many emerging countries that borrow on international markets.

Lenders are demanding higher returns than they can get from safer investments in the United States.

This can quickly cripple many emerging market governments, which are already facing steep increases in energy and food import costs due to the pandemic and the war in Ukraine.

They may see the amount of loans available to them shrink as investors choose to put their money in US investments.

“For countries already in difficulty, such as Turkey and Brazil and even more Argentina or Sri Lanka, it is very unwelcome because it raises the price of everything and causes a flow of capital to the United States in particular. “This makes financing their debt and economic activity more difficult and expensive,” Dor said.

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Market disruptions and economic crises cannot be ruled out.

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