By: Dr. Mike Campbell

The major weapon in the arsenal of a central bank to tackle inflation is its interest rate policy. The idea is that by making money “more expensive” people and firms will be more reluctant to borrow money for purchases or expansion and so demand eases and inflation is checked. It is known as choking off the money supply. When the global financial crisis struck, confidence evaporated from the markets and nobody was prepared to lend money. This produced a deep recession with substantial contractions in the world economy and rising unemployment.

In order to stimulate their economies, many of the world’s central banks slashed their interest rates to historic levels or even zero (Japan). In this case, the idea was to stimulate growth and spending by making money “cheap”. The economic crisis is behind us, but growth in the major economies (with the exception of China) has been fairly anaemic with unemployment in most countries staying stubbornly high. For this reason, most of the central banks have continued with their low interest rate policy, despite rising inflation in many countries.

The European Central Bank has decided to increase its interest rates for the second time since the onset of the global financial crisis last week. The ECB rate is now 0.25% higher at 1.5%. The forex markets have reacted badly to this because it is perceived that higher rates will make the recovery weaker, particularly in Portugal, Ireland and Greece which have major problems because of the sovereign debt crisis. The Eurozone inflation is running at 2.7%, 0.7% above its target level. ECB president Jean-Claude Trichet has reiterated the ECB’s stance on the importance of keeping inflation in check.

In contrast, the Bank of England has voted to keep its interest rate fixed at 0.5% for a further month.