Interest rates are a key factor in the cost of borrowing and the reward for saving money. What are interest rates? | Bank of England. The vast majority of people will experience interest rates in two ways: within bank accounts and on loans they have taken out. As for the former, savers benefit from higher interest rates whilst, for the latter, borrowers benefit from lower interest rates. Interest rates also impact the inflation rate. With stable and low levels of inflation being vital to a strong economy, it is therefore necessary to monitor the impact of interest rates. This article will evaluate the impact of various inflation rates and provide some ways in which the government could support stable inflation.

A high inflation rate leads to low economic growth as people cut back on non-essential spending to cope with increasing prices for essential purchases.  This is evidenced in the current cost of living crisis, caused by a combination of price shocks following Russias invasion of Ukraine and the legacy of the Liz Truss budget. 

Low inflation, however, can damage the economy during periods without economic growth. With stagnant growth, firms are more likely to stall innovation and investments. If this continues, firms can lower their prices to encourage people to spend more. Anticipation of future price reductions can often lead consumers to delay the purchase of large items to purchase them for less as deflation occurs. This spiral effect is known as a liquidity trap, which can ultimately increase unemployment and can be hard to recover from. The UK faced a liquidity trap after the 2008 financial crash, with the Bank of England reducing interest rates to historic lows, but consumers were still hesitant to spend. This situation highlights how the absence of growth and the presence of deflation can be equally as damaging as high inflation. 

Lower interest rates mean that savers will experience lower returns on saving. This incentivises savers to either spend or invest in other types of savings, for instance, stocks. As the cost of borrowing has reduced, they may take the opportunity to borrow. This particularly impacts firms that may see a low interest rate as an opportunity to expand as the cost to do so reduces.  The downside of this is that commercial banks will experience lower profits on loans, which increases the potential risk on loans, possibly reducing the amount banks are willing to lend.

High interest rates create the opposite problem. Increasing the cost of borrowing incentivises saving, which reduces the level of growth in the economy. Another impact of increased interest rates is the increase in the cost of mortgages, in particular flexible rates. This will increase monthly payments for homeowners who will have to pay the bank or lender, thus decreasing the amount of money that can be spent on other areas. In the most extreme cases, this can lead to homeowners losing their homes if they cannot pay the increased rate.

Interest rates are controlled by the Bank of England. The Bank of England is the independent central bank with monetary policy tools at their disposal to control inflation. Currently, the target for stable inflation is 2%, a target set by the government. By reducing or increasing interest rates, it has an inverse relationship with spending. As an increase in spending contributes to increased inflation and lower spending reduces inflation, interest rates can be used as a tool to control inflation.

Methods for controlling inflationi

Aside from interest rates, another way central banks can influence inflation is through reserve requirements. By setting a certain amount of money commercial banks must keep in reserves, the amount of loans that they can lend is limited. This lowers inflation by limiting the amount of money in circulation. 

Another way of influencing inflation rates is through quantitative easing.  Quantitative easing is the purchase of bonds either by banks or, more commonly, the government. This raises their price and helps to bring down long-term interest rates.  This increases the amount spent within the economy, thus increasing the money supply and leading to an increase in inflation and economic growth. Quantitative easing is mainly used in cases where the base rate is close to zero and cannot be lowered any further. Quantitative easing | Bank of England.

Interest rate changes, i.e. changes in the base rate, are the most direct way to influence inflation rates.  However, there are limits to the effectiveness. Changing the base rate assumes that domestic conditions are causing inflation levels. As was the case with the COVID-19 pandemic or the war in Ukraine, external factors that impact inflation can usually not be effectively countered by monetary policy.

An issue that faces monetary policy is that it is carried out by an independent central bank. Although the Bank of Englands decisions must remain free from political influence, policy may be undermined by fiscal policy carried out by the government. This was the case with the Liz Truss budget, which was at odds with the Bank of Englands strategy and forced the bank to intervene and buy government bonds to stabilise the economy instead of selling them to tackle inflation. 

The government can use fiscal policy to help keep the 2% inflation target.  One way of doing this is expansionary fiscal policy whereby there is a targeted increase in government spending in reaction to economic conditions. As government spending can increase inflation and provide a stimulus to the economy, it can be used as a way to escape a low inflation period. This would have been the case during the period 2013-16, but the government chose a period of austerity to reduce government spending, which in part expanded the period of low inflation.  Contractionary fiscal policy can be used to control a high inflationary period. This can manifest in the form of higher taxes and lower public spending.  These policies should be used in conjunction with monetary policy by the Bank of England for stable inflation and to react to any external price shocks which cause inflation to fluctuate from the target.

Current Inflation 

Inflation currently sits at 2.5% after inflation rates peaked at 2.6%, largely due to Labours budget. The impacts of Labours budget on inflation are uncertain but have the potential to cause an increase in inflation if companies pass on the increased costs associated with national insurance contributions to customers instead of accepting lower profits. This means the Monetary Policy Committee now expects inflation to only fall below the 2% target in mid-2027. Due to this predicted inflation being mostly domestic, it would primarily be controlled using monetary policy by the Bank of England. 

The Bank of Englands base rate is currently 4.75%.  This is the lowest the base rate has been since 2023 and is the start of a gradual reduction in the Bank of Englands base rate from record levels. The higher levels were enacted to curb high inflation caused by a combination of factors such as the war in Ukraine and the reaction to the Liz Truss budget.  Whilst it was originally expected that the Bank of England would continue to lower the base rate, the increase in inflation after Labours budget has increased uncertainty surrounding the next base rate announcement, with economists now predicting the base rate will not decrease until next year. Bank of England cuts interest rates to 4.75%.

A basic guide to interest rates

• Impacts what customers are charged for loans such as mortgages, as well as the interest rate they pay on savings accounts.
• An increase in rates is used to make lending harder, encouraging people to spend less and to help bring inflation down by reducing demand.
• Rates going down make it cheaper to lend but may lead to higher inflation rates.