What is... | April 11, 2011

What is monetary tightening?

Interest rates are going up again in several places prompting talk of "monetary tightening". In April 2011, the European Central Bank raised its main interest rate from 1.0% to 1.25%, its first hike – or first monetary tightening – in almost three years.

Several other central banks are part of a global trend that sees interest rates rising from historic lows reached during the latest global financial crisis. This tightening trend has implications for savers and borrowers alike.

Money’s too tight to mention
When central banks increase official interest rates, it is known as “monetary tightening”. This is because the central banks typically try to restrict (or tighten) economic growth by making it more expensive to borrow money. It helps to control the rate of inflation. On the flipside, central banks lowering official rates is known as “loosening” policy. At a technical level, official interest rates set the price banks pay when borrowing cash from the central bank in the country they are regulated in. It is common for banks to borrow from central banks to run day-to-day operations. 
At a consumer level, official interest rates are important because they influence the interest rate banks charge customers when lending money to borrowers and when paying interest to savers. 
The way official interest rates affect the economy is known as the “transmission mechanism”. An ECB flow diagram shows how changes in official interest rates can affect the economy.

What goes down…
Many central banks tighten or loosen monetary policy principally to ensure the rate of inflation does not move outside an agreed range. Tighter monetary policy (a higher interest rate) tends to bring the rate of inflation down as it makes money more expensive. The theory goes that tighter monetary policy reduces demand for loans and encourages consumers to save more and spend less. In turn, this slower spending cuts demand and makes it more difficult for companies to push up prices and for workers to seek higher wages, ultimately reducing inflation. 
Monetary policy is typically tightened (or loosened) in a series of small steps because the transmission mechanism between interest rates and the rate of growth is complicated and can change over time. Small steps aim to cut the risk monetary policy “overshoots” and growth slows too much or speeds up too quickly.

Oil and troubled waters
There is not always universal support for tightening monetary policy to lower inflation. Rises in the prices of essentials, such as food and energy, can drive up inflation no matter how quickly an economy is growing. Some economists argue recent inflation increases in several countries are result largely from rising oil and food prices,not excessive growth – and that raising interest rates can harm growth without achieving the desired outcome for inflation.
Respected business magazine The Economist wrote last month, for example, that the planned rate rise by the ECB was “too soon”. But others believe higher interest rates are needed to prevent rises in commodity prices flowing through to other products, causing a cycle that risks pushing inflation out of control.

Interesting times
Monetary tightening – or higher interest rates – will affect households in different ways. Savers may benefit from tightening as interest rates on their investments are likely to rise. But if these interest rates are still below the level of inflation then savers will lose out, as the value of their money will be eroded by higher prices.
The eZonomics blog post Can savers beat inflation? and a related video explain how savers can protect themselves. Borrowers with variable interest rates on their loans are likely to see their interest payments rise from monetary tightening, while those taking out new loans will also likely pay higher borrowing rates. It can pay to “stress test” budgets before borrowing to check if repayments can still be made if interest rates rise.


Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics