Interest rates have gone up a lot recently. The reason for that is there is an important link between interest rates and inflation.
Raising interest rates is the best way the Bank of England has to make sure inflation comes down and stays low. But it takes time to work. Usually, up to two years.
In short, higher interest rates will work because they will mean that less money will be spent in the UK (than if interest rates had not changed).
When overall spending in the economy falls, price rises slow down. And this brings down the UK’s inflation rate.
Higher interest rates can also increase the value of the pound compared to other currencies. That will tend to push down the prices of goods that businesses import from abroad, which also helps to lower inflation.
Higher interest rates mean I need to spend more on my mortgage. So how will that bring down overall spending (and inflation)?
People are already having to manage higher costs on food and household bills. And businesses, public services and charities are finding conditions difficult too.
We didn’t take the decision to raise interest rates lightly. But there is no easy way to fix the problem of higher inflation.
Higher interest rates will make sure inflation comes down by affecting spending habits in the UK.
This happens most directly if you have a mortgage or you are paying back a loan.
Either way, you may have to spend more on these things. And that means you will have less to spend on other things that are captured in the Consumer Price Index (CPI) measure of inflation. This is the measure of inflation that the Government asks us to target.
Food, housing, transport, and household bills are everyday essentials. You can’t choose not to spend on those. But you may put off buying other things.
Also, higher interest rates may mean you are less likely to want to take out a new loan to buy things unless you need to.
If you can save money, you might be more tempted to as interest you will get on any savings rises.
So even though your outgoings are higher your overall spending in the shops or online on other things will tend to go down.
Inflation was not caused by people spending too much. So why will higher interest rates work?
In the past, we’ve sometimes raised interest rates when the UK’s economy was growing very fast. In those times, we were concerned that booming economy would lead to higher inflation.
The causes of today’s inflation are different. One of the main causes was the sharp rise in the cost of energy and some food products that was caused by Russia’s invasion of Ukraine.
And just before that, there was also a surge in demand for products after the Covid lockdowns came to an end. Businesses had problems meeting that sudden demand.
Higher interest rates can’t stop the impact of these kinds of things. But they can slow down new causes of inflation that follow on from these shocks.
These new causes include things like businesses putting up their prices because they face higher costs themselves.
But if their customers have to cut back on spending, then businesses have to start offering more competitive prices to keep their customers.
The cost of food, heating and other bills have gone up more quickly over the last year than for many years. These things are essentials. People in the UK didn’t cause inflation because they spent too much on them.
But the way we get inflation down is just the same as if the economy was booming. Higher interest rates will reduce overall spending in the UK.
This page was last updated on 11 May 2023
(Bank of England)
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