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13 Oct 2022

Economy

Interest rates and inflation are closely connected elements in an economy. This explainer unpacks how they work, how interest rates affect economic issues like inflation – and ultimately, how that impacts people’s lives.

What are interest rates, and how do they impact people?

Interest is both the cost of borrowing money and the return for saving money with a bank. Interest rates are a percentage of the amount borrowed or saved over a year. If a £100 loan is given with a 5% interest rate, £105 would be owed a year later.

The higher the interest rates, the greater the cost to borrow or return to save. When interest rates are high, this can lead to fewer people taking out loans due to higher payments due. Higher interest rates will encourage more people to save than spend since their savings will accrue more interest.

“Where wages do not rise in line with inflation, people’s purchase power is reduced. People will have to either use more of their income to purchase the same goods or reduce their purchasing.”

If borrowing money, low-interest rates can lead to interest payments being more affordable for a greater percentage of people. If saving, the amount paid in interest will be much lower. Low-interest rates can stimulate the economy by providing a more favourable situation for investment and encouraging people to borrow and borrow more, especially through mortgages.

Consider the example; a family is looking to take a loan out, if interest rates are low, they might decide to apply for a loan. Once accepted, they would spend that loan throughout the economy, perhaps to buy a car or to build a house. Either way, that money would be injected into the economy, helping to spur economic growth. If interest rates are high, that same family might decide to hold off on getting a loan and instead place money into savings, delaying that money from entering the economy. By choosing to save instead of borrow-and-spend, the demand for whatever they might have spent that loan on will be lower. If there is too much demand, the supply cannot keep up which raises the price of that commodity, which can lead to inflation.

Housing

What is inflation, and how does it impact people?

Inflation represents a change in the rate at which the cost of goods and services increase over a period of time. The inflation rate is the percentage change in the cost of goods and services from one year to the next. Therefore, an inflation rate of 2% implies that prices increased on average by 2% from the year prior to the current year. If a coffee cost £3 last year and this year it costs £3.06, inflation is at 2%.

“Much of the world experienced demand-pull inflation during the pandemic as countries were easing restrictions and lockdowns. With less ability to spend, many people saved money.”

In the UK context, inflation is measured by the Office for National Statistics (ONS). The office collects 180,000 prices of around 700 common items, including the cost of housing, transport, food, and beverages. These prices go into what the ONS calls the ‘shopping basket’ that builds out the Consumer Prices Index (CPI). A percentage change in the CPI is referred to as the inflation rate.

High inflation indicates that goods and services are increasing in price quickly. This can make it difficult for businesses to set the right prices due to more frequent fluctuations in the cost of goods. It will also be difficult for people to know how much it will cost to buy goods and services. Where wages do not rise in line with inflation, people’s purchase power is reduced. People will have to either use more of their income to purchase the same goods or reduce their purchasing.

Energy bills

What causes inflation?

Inflation can be caused by factors internal and external to the economy. Economists do not always agree what the cause of inflation for a given situation. In general, the reason is grouped into two types, cost-push inflation and demand-pull inflation. Cost-push inflation occurs when businesses experience rising production costs and increase consumer prices to cover the change in cost. The rise in production cost can come from various factors, such as higher labour costs, global prices for raw materials, and depreciation in the currency’s exchange rate. Demand-pull inflation can occur when there is rapid growth in demand, usually when economic growth is happening too fast. In these cases, demand exceeds supply leading to businesses charging higher prices for the limited goods available.

Much of the world experienced demand-pull inflation during the pandemic as countries were easing restrictions and lockdowns. With less ability to spend, many people saved money. Once economies opened back up, people looked to spend since interest rates were low, giving them less incentive to save. However, supply chains were still recovering from the pandemic disruptions and could not keep up with the demand which led to higher prices. However, that has since changed, and now many countries, including the UK, are experiencing cost-push inflation. Since the Russian invasion of Ukraine, gas prices have risen sharply due to a more limited supply. This, in turn, affects the cost of anything that uses gas, whether to heat houses or to transport goods such as food. The cost is then transferred to the consumer through higher prices, leading to higher inflation.

How do central banks attempt to control inflation?

Central banks, such as the Bank of England (the central bank for the UK), attempt to control inflation by regulating the pace of economic activity. They normally try to regulate the pace by raising and lowering interest rates or, more specifically, in the UK context, Bank Rate. The Bank Rate is considered the most important interest rate in the UK, according to the Bank of England (BoE). Sometimes referred to as ‘the interest rate’. Bank Rate determines the interest rate the BoE pays to commercial banks that hold money with them. The rate that commercial banks charge people to borrow or pay on their savings is influenced by Bank Rate. While never the only reason interest rates will change, it is a major contributing factor. Through changing Bank Rate, the Bank of England can influence prices and inflation.

Fiscal challenges

Bank Rate is the short-term interest rate for lending to financial institutions set by the Bank of England: it usually feeds through very directly to the rates charged for variable rate mortgages and consumer credit.  Long-term interest rates, however, while influenced by short-term rates, are determined by the market. The risk-free long-term interest rate is that on government bonds; this will, in turn, determine the rates that homeowners will pay on fixed-rate mortgages and that companies will pay on longer-term borrowing.

How do central banks use interest rates?

Interest rates are a key tool that central banks, like the Bank of England, use to curb rising inflation. When central banks raise or lower Bank Rate, commercial banks will adjust their lending or savings interest rates according; this can help control inflation. They can slow public spending by increasing interest rates, making borrowing more expensive, thereby decreasing the demand for new loans. It will also incentivise people to save instead of spend, as their savings will earn more interest.

Central banks can also do the opposite to spur economic growth by lowering interest rates, providing more incentive to borrow rather than save. Lower interest rates make it more appealing for people to take out loans and spend that money in the economy. That is what most countries did during the pandemic to encourage economic growth. However, if interest rates are too low, it can lead to spending being higher than supply can handle, leading to higher inflation. The role of the central banks is to find a balance in inflation rates by setting interest rates accordingly.

Interest rates and inflation

What is the difference between fiscal and monetary policy?

A central bank oversees the state’s monetary policy, namely interest rates and money supply, while the government oversees fiscal policy (or taxes and public spending). The government sets the mandate of central banks, but they act independently of the government in deciding how to achieve this goal through interest rates. Central banks use interest rates to either boost (encourage spending) or slow the economy (encourage saving) as needed to achieve financial stability.

“The government sets the inflation target, and the Bank of England is then tasked with using monetary policy to achieve the inflation target set by the government.”

Governments can also attempt to control inflation through fiscal policy. Fiscal policy means the use of government spending to influence the economy e.g. through taxes and spending on public services. Governments can raise or cut taxes, and reduce or increase public spending in an attempt to influence economic activity, which can in turn impact the levels of inflation.

The rate set by the central bank influences the rate commercial banks offer to customers on loans and interest on savings. When interest rates are already low and more needs to be done to boost the economy, central banks can use quantitative easing, or buying of government bonds (gilts) or corporate bonds, to affect inflation. Bonds are essential an I.O.U or loan between a lender and borrower. In this case, the central bank is the borrower. This increases the price of bonds, which means the gilt yield, or interest rate paid on bonds, goes down. This lower interest rate on government or corporate bonds feeds through to lower interest rates on loans, such as mortgages. This can boost spending in the economy and keep inflation low.

Treasury

What is the Bank of England, and why does it control interest rates?

The Bank of England is tasked with the role of being the central bank for all of the United Kingdom. The Bank of England was established as the central bank of the United Kingdom in 1694 to act as the banker to the government. It has since expanded that role to maintaining monetary stability in the UK economy. It does so through monetary policy, including using its tools of setting Bank Rate or interest rates and buying bonds.  It is an independent institution from the government, which means it should be free from political interference. The government sets the inflation target, and the Bank of England is then tasked with using monetary policy to achieve the inflation target set by the government. The inflation target is a political decision, but the BoE has independence in monetary policy on how to achieve that goal.

By Stephen Hunsaker, Research Assistant, UK in a Changing Europe. 

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