How do interest rates affect inflation?

The relationship between inflation and interest rates

Interest rates and inflation. They're often in the headlines, for better or worse, but what are they, and how are the two interlinked? How does rising inflation affect the prices you pay for goods and services? And why does the Bank of England (BoE) use interest rates to help control inflation? Read on, to find out more.

What is inflation?

Despite the often negative press that accompanies any mention of the word, ‘inflation’ is simply a term used to describe the price increases of goods and services. The speed at which these prices rise is known as the 'rate of inflation'.

Kept low and stable, it's a natural part of a healthy economy. Problems arise when inflation becomes high or unstable, affecting people's spending power by reducing their wages and savings in real terms. Put simply, this means the pound in your pocket no longer buys as much as it once did. Over time, this is inevitable, as inflation rises steadily, but sharp and unsustainable increases mean there's no time for wages to catch up, while the value of savings pots are dramatically reduced. This may also affect people's ability to put long-term financial plans in place. That's why the Bank of England is tasked by the government to keep the rate of inflation at a reasonable level known as an ‘inflation target’.

The UK’s current inflation target

The UK’s inflation target is set by the government and currently stands at 2% (as of January 2023). However, throughout 2022 and into 2023, this target has not been met, with inflation reaching in excess of 10%. This has contributed to the current cost of living crisis.

You can find out how inflation can potentially affect your cash savings with our inflation calculator.

How is the inflation rate calculated?

The actual rate of inflation is measured by the Office for National Statistics (ONS). The ONS looks at the prices of more than 700 items regularly bought by consumers throughout the UK. These range from everyday staples such as rice, bread and milk, to items such as bus and cinema tickets, along with motor vehicles, holidays and more. The prices are totalled to give an overall figure, known as the Consumer Prices Index (CPI).

The CPI is compared to what it was a year ago, with the difference used to calculate the rate of inflation.

How interest rate changes can impact inflation – At a glance

The table below shows the typical relationship between the two when inflation is high and the Bank of England is trying to bring it back down to the target level (usually around 2%):

It isn’t always the case that low interest rates go hand-in-hand with rising inflation. Following the financial crisis of 2008, and for more than a decade afterwards, interest rates remained low alongside inflation. In very recent years, global geopolitical events and other factors such as international supply chain disruptions have contributed to rising inflation, not just in the UK but in other developed economies too.

What causes inflation?

Numerous factors can contribute to inflation, with some leading to sharper rises than others. Potential causes of inflation might be:

• Global upheaval – Events that disrupt supply chains, such as natural disasters or war, can lead to difficulty sourcing materials or food staples, creating shortages and leading to price increases.
• An increase in disposable income – More spending power, through cheaper borrowing, can lead to increased demand on products or services, resulting in shortages or supply difficulties, which can mean a rise in prices.
• Increase in production costs – A rise in the cost of raw materials used in the manufacture of goods can see those costs passed along the line, onto customers.

One measure used by the Bank of England to combat high inflation is the adjustment of interest rates.

What are interest rates?

Interest is defined by the Bank of England as 'the cost for borrowing money or the reward for saving'. The interest rate is the percentage level at which this is either charged or paid.

The UK's key interest rate is known as the 'base rate' or 'bank rate'. Set by the Bank of England, it has a direct influence on the rates of interest set by high street banks and other lenders, which then impacts mortgages, loans and savings.

When the base rate of interest rises, it usually leads to the cost of borrowing going up. This is a key measure the Bank of England uses to try and curb high inflation.

How do interest rates affect inflation?

Interest rates and inflation tend to exist in an inverse relationship. In this context it means that when one is low, the other tends to be high. So, when interest rates fall, there's a possibility inflation will rise. If this is the case, then it may be necessary for interest rates to increase to bring inflation back down.

The reason low interest rates can cause inflation to rise is because of the lower cost of borrowing. This can lead to more money in the economy through consumer spending because people have greater access to ’cheaper’ money such as loans. Increased spending can see prices rise due to the surge in demand that goods and service providers struggle to meet. As availability dries up, but demand remains, suppliers find themselves in a position to charge more. As a result, Inflation starts to rise.

How does the Bank of England tackle inflation?

One of the Bank of England's main responsibilities is to find a healthy balance between inflation and interest rates. A balance where neither can deal significant damage to the economy or impact people’s everyday living costs.

When inflation rises, the Bank steps in by raising the base interest rate. This measure is intended to discourage people from taking out loans and other debts, making it less affordable due to the increased interest on repayments. It also makes the prospect of short-term saving more attractive, as banks and building societies normally reflect some of this rise in the interest rates they offer customers on savings accounts.

These measures are intended to take surplus money out of the economy, curbing consumer spending and ultimately reducing inflation.

Sometimes though, it isn't enough to prevent unsustainable rises in the rate of inflation. Coupled with events elsewhere in the world continuing to cause major disruption (such as the war in Ukraine and supply chain problems in China), it has led to soaring inflation and interest rates at their highest since 2008.

While the latter will cause short-term pain, particularly to those with mortgages and other financial debts, it should hopefully play its part in bringing inflation down towards the long-term 2% target.

If you're worried about the impact of inflation and rising interest rates on your finances, speak to a Specialist Financial Adviser from Wesleyan Financial Services, for tailored advice and support.