Why some rate hikes can't be cancelled out

One of the worst-explained features of economics is that even as the inflation rate falls, prices keep going up. 

Economists tend to refer to the annual inflation rate, which tells us how the price of a basket of goods and services compares with its price in the same month a year ago. Clearly, a 10 per cent rate means that the price of this basket has increased by that same amount – a feeling we are all too familiar with in the UK. 

But should the inflation rate drop significantly, all the way back to 2 per cent, that basket is still getting more expensive. Despite headlines (mine included) proclaiming the good news of lower inflation rates, households probably feel little relief. Over the past three years, the price of this representative basket of goods and services has increased by a cumulative 20 per cent. 

It is only via deflation (negative inflation) that the cost would start to fall again. As the chart shows, the UK last experienced deflation in October 2015, when the annual rate of consumer price index (CPI) inflation hit -0.1 per cent. But policymakers are keen to avoid outcomes like these for fear of a ‘deflationary spiral’ setting in. After all, if prices are falling, why not wait to hire, make purchases or invest? As a result, such episodes are usually rare and short-lived. In practice, this means that today’s higher price level will not be reversed. 

Higher interest rates, on the other hand, can be more easily undone. Mortgage holders have felt the impact of higher rates acutely: the average rate on a fixed two-year mortgage has shot from around 2 per cent to 5.5 per cent since late 2021. The impact on monthly repayments has been eye-watering: assume an average property price of £290,000 and a 75 per cent loan to value (LTV), and payments have increased from £920 to £1,336 over the period. As interest rates fall again, mortgage rates will start to drop. Rate cuts can, to an extent, undo the impact of higher interest rates. 

Traditionally, economists think of monetary policy as a useful tool for smoothing out the economic cycle. But new research suggests that we would be wrong to see the effects of monetary policy as only temporary.

Economists at the Federal Reserve Bank of San Francisco looked at international data from 1900 onwards and found that higher interest rates can reduce potential output even a decade on. Their research implied that higher rates slow economic activity and tighten credit conditions, which leads to lower investment, including in R&D. This ultimately means lower productivity and lower capital stock, which is bad news for long-term economic performance.

In 2023, economists Yueran Ma and Kaspar Zimmermann found further evidence of the impact of higher interest rates on innovation. Their research found that a 100 basis point ‘tightening shock’ sees R&D spending decline by between 1 and 3 per cent, and venture capital investment fall by about 25 per cent over the following three years. Patent activity also drops significantly. 

Crucially, the researchers found that higher rates exert this long-term impact through two channels. By lowering demand, rate hikes reduce the profitability of innovation, while they also tighten financial market conditions. The economists concluded that “monetary policy may affect the productive capacity of the economy in the longer term, in addition to the well recognised near-term effects”. This all means that while central banks can cut high rates, they might not be able to reverse their impact entirely. If this research is anything to go by, the impact on innovation and R&D could linger for years.