Interest Rate Hikes: A Necessary Evil?

Photo by Subarno from Freepik

By

Ruth Umoru

Date Published

May 24, 2022

Category

Insight

IN CASE YOU MISSED IT

I’m sure you’ve heard that on Wednesday, May 4th, the Federal Reserve (The American Central Bank) increased Interest rates by a half percentage point (0.5%) in an attempt to curtail the country’s increasing inflation. This caused the stock markets to experience what some might call a “violent” decline as the markets experienced the biggest single-day decline since 2020 the following day.

In the same vein, the Bank of England increased interest rates by a quarter percentage point 0.25% after its inflation rate hit 7%, which is the highest it has been in 30 years.

Backstory…

So here’s the gist; the U.S is apparently going through the highest inflation (Sustained general Increase in prices of goods and services) it has seen since December 1981 (over 40 years). With declining purchasing power and the strength of the US dollar at risk, the Fed decided to raise rates (the significance of which we will discuss later), as a tool to tackle the inflation problem. 

To create a clearer picture, the chart below shows the trend of inflation in the US over the past year.

What this means is that at this rate, fewer goods and services will be purchased with the same amount of money or more money will be needed to purchase the same amount of goods and services that could have been gotten at a previous date and time. For context, a loaf of bread that cost $5 in April 2021, would likely be selling for $5.22 in May 2022. 

The Inflation Problem

Remember when the Nigerian Government increased NYSC stipends (allowee) from 19,800 naira to 33,000 naira? If you were serving at the time, you would know that wearing the Khaki was like an invitation to be billed or to pay higher cab fares because you were now perceived to be richer. You most likely heard the nickname “Corper 33” as well. 

Similarly, In reducing the economic impact of the pandemic, the United States, employed fiscal and monetary policies through rescue plans, which injected around $3.7 Trillion into the economy. The government focused on public health incentives, unemployment benefits, direct stimulus payments to individuals, forgivable small business administration loans and guarantees, lower rates, loan modifications, and so on, all of which helped to cushion the impact of the pandemic on the economy.

Consequently, with more money in circulation chasing fewer goods and services, especially with supply chain struggles, the prices of goods and services have maintained a bullish trend.

Interest Rates matter because…

In the economy, interest rates are used to facilitate access to financial services. It has an impact on the savings and investment decisions of individuals. It also controls how money moves from lenders to borrowers. Basically, interest rates refer to the cost of borrowing money. 

Rates determine the cost of borrowing for businesses. With higher rates, businesses would have to pay higher amounts of money to pay off their debt, thereby reducing net profits, and affecting investor expectations. This could explain the responsive decline in stock markets discussed earlier. 

So why the hikes?

With interest rates being near zero for the past two years, money has been pretty easy to move around. So, by increasing the rates of interest, money becomes more expensive to borrow, which means that you pay more money for borrowing money (sho’ get?)

In essence, higher interest rates limit people’s access to money, and in turn, control the amount of money in circulation. 

Why should you care?

Well, despite our foreign debt being as high as 38.4 Billion USD, with debt service to revenue ratio hitting 96%, increased interest rates inevitably mean that we have to pay more money to service our debts or get new loans. This is not good for a country struggling with poor revenue generation.

Silver Lining

In the event that rate hikes lead to success in curbing inflation in the American and English economies, it could serve as a reference point for other countries looking to solve the price instability problem. Nigeria, for instance, according to the NBS has an inflation rate of 15.92% as of March 2022.

It is important though, to note that our inflation problems are majorly supply-side driven due to food shortages, as a result of insecurity and poor access to funding and innovative equipment (topic for another day), and those might need to be resolved before we jump quickly into interest rate hikes.

My 2 cents or kobo

Interest rate hikes pose a risk of slowed economic activity. Consumption is likely to decrease and unemployment rates increase. Just as we've seen with the decline in stock markets discussed above, there’s already an indication of decreased investor confidence in the financial markets’ ability to cope with rate hikes.

There’s still a likelihood that there are more rate hikes on the way. Policymakers would need to be extremely strategic with these, being careful not to raise interest rates too quickly, to avoid forcing businesses to dismiss people or send their countries into recession.

As always, we would be glad to hear your thoughts. So, kindly share.

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Disclaimer: This information in this article is NOT investment advice. It is intended for information and entertainment purposes only.

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