Why Do Central Banks Raise Base Interest Rates, and What Are the Effects?

Hello, this is Bitpunk. Today we'll look at why central banks around the world, such as the Bank of Korea, raise their base interest rates and what impact this has.

Why Central Banks Raise Interest Rates

Why do central banks raise interest rates? After all, higher rates mean heavier loan burdens and, comparatively, a slowing economy. The reason is that if the economy overheats too much, it can lead to inflation, rising prices, and even an economic crisis.

You probably know that, because of the recent spread of the coronavirus, governments around the world printed an unprecedented amount of money. On top of that, in a crisis where economic activity is shrinking, governments and banks keep ultra-low interest rates to encourage business activity and consumption. As a result, more money than before is released into the market, and businesses and households can borrow money cheaply to run their businesses and invest. The problem is the inflation and asset price bubbles that follow.

As the 2007 U.S. subprime mortgage crisis showed, reckless lending and household debt led to a severe global economic crisis in 2008. Of course, Korea's economic influence isn't as large as that of the U.S., but fundamentally, central banks take preemptive measures such as raising the base rate in order to ultimately keep this kind of market collapse under control.

Rate Hikes and Economic Growth

As mentioned earlier, when interest rates rise, economic growth is expected to slow somewhat. However, once the economic growth target has been reached by releasing money into the market, the government controls excessive inflation through anti-quantitative-easing policies such as tapering. This is because economic growth comes with inflation, which lowers the value of money and pushes prices up. In this situation, businesses and capitalists may earn returns that outpace rising prices, but the burden grows heavier for ordinary salaried workers and everyday people who live on their paychecks. Through rate hikes, the government aims to achieve an appropriate level of economic growth while keeping inflation under control at the same time.

Curbing Market Overheating

In Korea's case, while ultra-low interest rates were maintained after the COVID-19 outbreak, household debt grew sharply and the prices of almost every asset in the market rose explosively. So much so that a new term, "byeorak-geoji" (overnight beggar), was coined. "Byeorak-geoji" refers to the situation where, because almost every asset rose by at least 20% over the course of this year, people who held only cash saw their assets fall by 20% in relative terms. In other words, the value of their money suddenly dropped.

As a lot of money was released into the market due to the spread of COVID-19, banks also offered ultra-low-interest loans at the same time. People invested in real estate, stocks, Bitcoin, and more. The general assessment among experts is that, as a result, the market is overheating, with assets becoming excessively overvalued.

Raising interest rates makes it comparatively harder to get a loan, which can cool down an overheated market to some extent. For reference, Korea's household debt in 2021 rose more than 10% from the previous year to KRW 1,805 trillion, hitting an all-time high. If the central bank doesn't step in to control household lending, an even bigger crisis could follow.

Wrapping Up

Central banks raise base interest rates for reasons such as preventing inflation, rising prices, and market overheating. Through this, they aim to achieve an appropriate economic growth rate and foster a healthy market economy.