Why are interest rates rising?

By Michelle Murphy and Stephen Sale

Interest rates dictate the cost of borrowing money, or the reward for saving.

One of the main influences on interest rates is the Bank of England’s “Base Rate”.  This influences many other interest rates in the economy, including what you might pay for a loan/mortgage or receive on a savings account.

On Thursday 4th August, the Bank of England raised the base rate by 0.5% to 1.75%.  This is the highest the base rate has been since 2008, although still low by historic standards. 

This is to stop prices rising so fast and bring down the rate of inflation. Parliament tasks the Bank of England with keeping the rate of inflation at 2% per annum.

What is inflation and why is it so high?

Inflation is the measure of how much the cost of goods and services go up over time.  Inflation is currently around 10% per annum, with some predicting that it could increase to 15% by the end of the year.

Higher energy prices are one of the main causes of high inflation.  Russia’s invasion of Ukraine has led to large increases in the price of gas, which has doubled since May.  Higher prices for the goods we buy from abroad have also played a role.  During the Covid pandemic, people began to buy more goods.  However, suppliers had problems obtaining sufficient stock to meet customer demand.  This has led to higher prices, particularly for goods imported from abroad.

There is also pressure on prices from developments in the UK.  Businesses are charging more for their products and services because of the higher costs they face. In addition, there are more job vacancies than there are applicants and so employers are having to offer higher wages to attract employees.

How do higher interest rates help to bring down inflation?

Increasing interest rates makes borrowing money more expensive and encourages people to save.  Therefore, people will spend less within the economy.  This then reduces the demand for goods and services, slowing the rate at which prices are rising.

Impact and Outlook

Borrowers will find the cost of their loans/mortgages will increase over time with increasing interest rates, whilst savers will be rewarded with more generous interest rates on their savings.

Precisely where interest rates will go depends on what happens in the economy and the consequent actions from the Bank of England over the coming years.  The quicker inflation comes under control, the less there will be a need for further increases in interest rates.  The Bank of England review the position regularly, around every 6 weeks.  Current expectations are that rates will continue to rise during the remainder of 2022.

A potential consequence of increasing interest rates is that it pushes the economy into recession.  As household disposable income reduces, there is less discretionary spending and this reduces the size of the economy.

Whilst the economy may enter recession, there is a reasonable prospect it will be shallow by historic standards given the strength of the employment market.  Once inflation comes down to more manageable levels, this should create a suitable environment for economic growth to return.