In the previous parts, we looked into what interest rates are and how they can impact the daily lives of people like you and I, all the way to large corporations, financial institutions and the wider economy.

So we already know that interest rates have a huge impact on the level of economic activity within an economy. Generally speaking, higher interest rates reduce economic activity while lower interest rates lead to increased levels of economic activity. This was discussed in previous parts of the series, but to sum it up, interest rates decide the cost of borrowing money (or debt).

Lower interest rates make borrowing cheaper for everyone, which increases the amount of debt that taken out by individuals, financial institutions, governments and most importantly businesses. This money can then be used to build out housing, schools, roads, railways, stores, factories and more. Debt is then also used to buy said houses, vehicles and other goods.

Much of that money goes back to businesses, which allow them to build up capital. So next time they need to borrow more money, banks turn around and say: hey, you own a ton of assets and are making money, we feel comfortable lending you more. The cycle repeats itself, only this time, more debt and even more economic growth.

But if you follow the news, you’ll know that central banks all over the world increase and decrease interest rates all the time. Ever heard the headline ‘Bank of England cuts interest rates cut to lowest levels in two years’, or ‘Federal Reserve hikes interest rates to the highest level seen in 10 years’. So that begs the question: If low interest rates are known to drive economic growth, then why aren’t interest rates always stay low?

With economic growth and low interest rates comes more access to borrowing, which results in more spending.

Then problem is, is that we as humans have almost infinite desires – more than that of any animal species in historical existence. Humans have been at the top of the food chain for centuries. Think about it, we could’ve stayed as hunter-gatherers, but we desired more and introduced modern farming methods. That meant that one man could feed hundreds, freeing us to build everything around us today. We’ve had everything we needed to live for centuries, but that doesn’t stop us wanting more.

Maybe think about your own life for a second – maybe you visited a country that you’ve always been dreamt about. Feels great, after having done it right? But is that it? Are all your life’s desires quashed now? No. Onto the next thing.

Turns out that people and businesses are the same! When borrowing is super cheap, they will borrow as much as they need to tick off their never-ending lists of wants. A £100M sales target becomes a £120M target the next year. To fulfil those wants? We need resources. But resources are limited – for example there are only so many builders that can build houses and only so many planes that can land at London Heathrow Airport for your flight back.

So what happens when we have infinite wants and finite resources? In other words, what happens when demand is high and supply is restricted?

Demand has to match supply – so either supply has to go up, or demand has to go down. In a finite resource scenario, more often than not, it’s demand that initially takes the hit.

Have you ever gone shopping for something, seen something and said to yourself ‘I’d actually look fly in wearing that.’ You picture yourself in the suit or dress, and all the eyes on you when you walk into the room, all nice compliments that people are about to give you, ahh the sweet smell of validation….

…but you put it down because it was way to expensive.

You had a burning desire to buy that item, yet didn’t buy it because of the price.

That’s exactly how you kill demand. Although chances are, someone with a bit more money to spend will end up buying it anyway.

Just increase prices just by enough so that demand matches supply. Not too much so that barely anyone can afford it, but not too little that you’re sold out for weeks.

What you’ve just seen there is basic supply and demand economics. But what happens when that happens across the board, you know, when everyone is able to spend to their hearts content by borrowing tons of money from the banks for really cheap?

More money circulates the economy, making every unit of currency worth less, causing the devaluation of currency over time. Prices increase across the board. That’s called inflation.

And they’ll keep increasing for as long as borrowing is cheap. Leave it too cheap for too long and this can lead to something called hyperinflation. This is when prices of everything so quickly and by so much, that the majority of people can no longer afford anything. That’s what happened to Venezuela in 2017, completely destroying its economy, condemning its population to mass starvation and poverty. Similar things happened during Weimar-era Germany and in Zimbabwe recently, although it’s important to note that multiple other factors were at play in every instance.

Hyperinflation is what almost happened during the cost of living crisis in 2021 here in the UK and many countries across the globe. The only way to prevent that?

That’s right! Increase interest rates, make borrowing so expensive that the whole economy wants to spend less.

And increase the interest rates they did – the Bank of England base rate went from 0.1% to 5.25% from 2021 to mid 2023. The base cost of borrowing in the UK was made 52x higher in space of less than 2 years. If you’re in the EU or the US, your central banks did the same.

But here’s the thing, inflation is also needed to make sure that people keep spending – this because if people know that prices will go up in the future, they’ll want to spend their money now, before prices go up. This is what keeps businesses and jobs alive. So how much inflation is just right?

It depends on the country, but in most developed nations, it’s 2%, it’s called the Goldilocks Zone of inflation. If inflation is higher, expect interest rates to go up. If it’s lower, expect it to go down (there’s also another factor at play here, expect that to be covered in a future post).

Ladies and gentlemen, we’ve just uncovered the concept of interest rate cycles!

To summarise interest cycles:

1. Low interest rates make borrowing cheap.
2. Cheaper borrowing means that everyone can and will borrow their way into purchases, which increases economic spending.
3. This increases the demand for goods and services that are limited in supply.
4. Prices go up until demand matches supply.
5. Interest rates, kept low for too long causes inflation, which becomes hyperinflation if left to run – this raises prices so high that it makes everything unaffordable to most people.
6. Interest rates need to increase enough to cool economic activity enough to keep inflation at 2% – the goldilocks zone of inflation.
7. If the economy isn’t spending as much as it needs to to keep jobs and businesses alive, inflation will fall.
8. If inflation falls below 2%, interest rates will be lowered and the cycle repeats itself.

At that time of writing, inflation rates are above 2%, which means interest rates are still relatively high. Unfortunately that means mortgages are harder to get, making housing less affordable. It makes car financing more expensive. For you smaller business owners out there, you may have noticed that business loans are more expensive as well.

All thanks to us, the central banks and interest rates.

But hey, at least we live in a world where we can afford the essentials, even if it means many of us can’t buy everything we want.