0: When central banks raise interest rates, it's big news

4: The bank is judging...

5: ...that the only way they can try to pull down inflation...

8: ...is to carry on raising interest rates

11: We're going to see rising rates

12: Rising interest rates that will make the cost of borrowing go up

16: It can send ripples across the whole economy

20: It can sink consumer confidence...

22: ...result in fewer jobs and lower wages, and cause stock prices to fall

27: If they go too far too fast, it can tip economies into recession

32: So why do central banks raise interest rates?

46: Let's start with the basics

48: If you borrow money, you'll have to pay back a little extra...

51: ...to make it worthwhile for the lender

53: Well, I think we can make you this loan, you have a good reputation...

56: ...we know you're reliable

58: I'm glad you think so

59: This is the interest rate

62: So if you are taking out a loan...

64: ...you want the interest rate to be as low as possible...

66: ...so you don't have to pay that much back

69: On the flip side, if you want to save money...

72: ...then a high interest rate means you can earn more on your savings

76: See it as a reward for leaving money in your account

79: But the size of your reward depends on the circumstances

83: There's no single interest rate in the economy

86: You've got thousands of banks setting their own commercial rates

90: That's all influenced, though, by the interest rate that the central bank sets

97: A central bank is like a bank for banks

100: Just like you and your savings account...

102: ...banks also earn interest when they leave money with the central bank

107: Commercial banks have these things called reserves

110: So that's a bit like their cash on hand

113: Commercial banks lend those excess reserves to each other at an interest rate...

118: ...and they also can deposit their excess reserves at the central bank

122: And when they do that, they can earn an interest rate

125: Ordinary people can't access the interest rate on the excess reserves...

130: ...but it still affects them

132: And that's the idea

134: When central banks raise interest rates...

137: ...they're trying to control inflation—how fast prices rise for everyone

142: They were £1.29, now they're £1.39, and that's in the space of four weeks

146: Central banks like the Fed or the Bank of England or the European Central Bank...

151: ...are all trying to hit an inflation target of 2%

155: Interest rates are a really powerful tool that they have to do that

160: If inflation is seen as too high, that's when banks raise interest rates

166: The change spreads through the financial system and slows down the rate of inflation

172: Here's how

173: A rise in interest rates from a central bank...

176: ...means that a commercial bank will earn more on their reserves

180: They might make more from keeping their money in a central bank than lending it out

185: So if they do lend it out, they'll raise their interest rates...

189: ...to make it worth their while

192: How that affects consumers depends on the economy

195: Take mortgages

197: In places like Finland or Australia...

200: ...lots of people have mortgages with variable interest rates

204: If you've got a variable-rate mortgage, where the interest rate that you pay...

209: ...is linked to the central bank's interest rate...

212: ...then higher interest rates mean that, essentially, immediately...

216: ...the higher rate will translate into less cash to spend on other things

220: Less spare cash means households will spend less

224: And less spending means businesses will be warier of raising prices

229: This should lower inflation

231: In other countries, like America or Canada...

234: ...a bigger share of mortgages are set at fixed rates

238: People with fixed rates are protected...

240: ...against the direct effects of an interest rate rise...

244: ...but will still feel an indirect impact

247: Higher interest rates mean that mortgages will become more expensive

253: If that is affecting all new buyers, then house prices will begin to fall

259: And that will make everyone who owns a home feel poorer...

263: ...and therefore they might spend less

265: Lower spending will translate into lower inflation

269: And it's not just consumers who will tighten the purse strings

273: When interest rates rise...

275: ...then businesses will find it more expensive to borrow and invest

280: That generally means less economic activity

283: It might mean fewer jobs are created

288: Fewer jobs and lower wages could mean less money for households...

293: ...and consumer confidence might suffer

296: Which also means less spending

298: People are grappling with a decline in real wages...

302: ...meaning their money buys less

303: When interest rates rise, that will tend to slow down spending, investment...

308: ...and generally depress economic activity

312: Overall that will make businesses more reluctant to raise their prices...

317: ...and that will tend to pull back inflation

319: It sounds straightforward, right?

322: But the trick is judging how far to go

325: In 1981, the Federal Reserve, America's central bank...

330: ...allowed interest rates to rise to a whopping 19%

334: The move curbed inflation, but it led to widespread economic pain

340: I regret to say that we're in the worst economic mess since the Great Depression

346: It is very difficult to get inflation under control...

350: ...without severely denting economic activity

353: In America, it's been over 70 years since they've managed to get inflation down...

360: ...from over 5% without causing a recession

364: A little inflation is OK

367: It keeps the economy moving at a sensible speed

370: But inflation staying high for too long is a problem

374: Higher prices means employees will need higher wages...

378: ...pushing up costs for businesses

380: That could drive up prices further...

382: ...potentially leading to an upward spiral of wages and prices

386: Retail inflation in India has surged to 7.8%

389: The combination of tepid economic activity and high inflation...

393: ...poses serious challenges for the Indian economy going forward

396: Central bankers are really concerned about setting expectations of inflation

401: The idea is that, if it can show that it is credible...

404: ...that it will always act to get inflation back down to 2%...

409: ...then maybe it won't have to raise interest rates...

413: ...and then lower them in this kind of seesaw fashion

416: Raising interest rates can slow an economy right down

420: The trouble is, the brake pedal has a delay

424: It can take as long as two years...

426: ...to see the full results from interest rate changes

429: Central banks know this

431: So when they set interest rates...

433: ...they're actually trying to read the road ahead

436: But predicting the future isn't easy

440: The problem is it's difficult for the central bank to work out...

444: ...whether the inflation will fall back on its own

447: And even when central banks do get it right...

450: ...they might still cause a crash

452: It may be a blunt instrument, but raising interest rates...

457: ...is still central banks' main tool for taming inflation

461: Central bankers would say that, yes, raising interest rates can be painful

465: Slowing down the economy is not fun

468: But it's worth it

470: It's worth it to get low and steady inflation...

473: ...so that in the long run, you don't have to think about it

478: Thank you for watching

479: To read more of our coverage on interest rates, click the link

483: And don't forget to subscribe