Please note this article is for general educational purposes. You might wish to seek professional advice.
Most of us are aware of inflation. It’s always being mentioned in the news, often in relation to government targets or the cost of living. What we may not be sure of is how it affects interest rates and, in turn, our mortgages and savings.
Therefore, we created this blog to give you an insight into how inflation could affect you.
How does the inflation rate affect interest rates?
The Office for National Statistics measures the rate of inflation in the UK each month. To do so, it looks at the prices of around 700 commonly bought items. This ‘basket’ of goods and services is designed to represent what, on average, people buy. It covers everything from bread to bus fares and holidays. The overall cost of the basket is known as the Consumer Price Index (CPI). It’s reviewed from time to time, to make sure it’s relevant to changes in our spending habits.
Inflation is calculated by comparing the CPI in the current month, with the same month in the previous year. The change in prices over the year is the rate of inflation. So, if the rate of inflation is 3%, then a basket that cost £100 a year ago would cost £103 today.
The rate of inflation changes all the time. However, the Government has set the Bank of England a target of keeping it at 2% annually to maintain economic stability. Over the last 20 years inflation has broadly stayed around this level, although at times it has been higher or lower.
The main tool the Bank of England has to manage inflation is setting the Bank Rate. You may also hear the Bank Rate referred to as the ‘Bank of England base rate’ or simply ‘the interest rate’.
The Bank Rate is the interest rate that the Bank of England pays to banks and building societies that hold money with them. It therefore influences the rates that they charge people to borrow money, or pay on savings balances.
How does raising interest rates help inflation?
Raising interest rates helps reduce inflation by increasing borrowing costs and encouraging people to save. This means that businesses and consumers tend to spend less, leading to lower demand.
As a result, companies may respond by raising their prices more slowly to help boost sales. This can lead to lower costs for consumers, which impacts the basket of goods and services used to calculate the CPI. This means that over time the CPI falls, which indicates that inflation is lower.
The opposite of this is also true. Lower interest rates mean it’s cheaper to borrow money and there’s less incentive to save. In this situation people tend to spend more, which increases the rate of inflation.
How does inflation affect mortgage rates?
As we mentioned, the Bank Rate impacts the interest rates that banks and building societies offer their customers. This includes the rate of interest they charge on mortgages. For example, if inflation is higher than 2%, the Bank of England might increase the Bank Rate to help reduce it.
Banks and building societies may then reflect the increased Bank Rate in their mortgage interest rates. Therefore, if you have an existing mortgage but aren’t on a fixed rate deal, you may see your payments increase. If you’re looking to take out a new mortgage, or are coming to the end of a fixed rate deal, the rates on offer will likely be higher than those previously available.
The reverse could happen if the Base Rate is cut. Fixed rate mortgage holders would be unaffected until their deal comes to an end, but those on variable rates could see their payments decrease.
Does inflation affect savings interest rates?
Savings interest rates can also be affected by rising inflation. However, rising interest rates are likely to be good news for savers. A higher Bank Rate may be passed on to customers by banks and building societies. This would give them a better return on their savings. The opposite may happen if the Base Rate goes down, as banks and building societies may lower their interest rates in response.
Building societies must carefully consider savings and mortgage interest rates in relation to inflation and changes to the Bank of England’s base rate to remain both competitive and financially health
If you have a fixed rate savings account, a change in the Base Rate won’t affect you until your fixed period ends though.
In summary, the Bank of England uses the Base Rate to manage inflation. This is because changing it influences the interest rates offered to mortgage and savings customers by banks and building societies.
Higher rates lead to higher borrowing costs, which reduces demand and encourages saving. This leads to lower price rises, which in time, reduces inflation.
Lower rates boost people’s spending power by reducing the cost of borrowing and giving them less incentive to save. This may lead to increasing price rises and higher inflation over time.
