How Do Interest Rates Affect Inflation and What Does It All Mean for the Economy?

So how do interest rates affect inflation? It’s a question that has a seemingly simple answer. But in practice, as so often is the case, things are a bit more complicated.

In theory, as interest rates rise, inflation should slow down[1]. When rates are low, inflation could rise. Generally, the belief is that when interest rates rise (via the base rate), it should lead to increased savings rates at the banks.

As such, people will be encouraged to save rather than spend. If people aren’t spending, demand drops for goods and services. Retailers and the like will be tempted to lower their prices to draw back customers.

What’s more, higher rates can raise the value of the pound compared to other currencies[2]. This could push down the prices of goods that businesses import from abroad, which helps to lower inflation.

But, interest rate hikes can only go so far. The supply of money, macroeconomic environment, and supply and demand in the wider market can all affect inflation. There’s only so much the Bank of England (BoE) can do about all this.

This may be especially evident at the moment. In fact, for many, the obvious question may not be how do interest rates affect inflation, but why haven’t base rate hikes been working as well as they could have?

Why haven’t rate hikes been working that well?

The UK, and indeed much of the world, has been struggling against a cost-of-living crisis for a while now. Peaking at 11.1% in October 2022, inflation didn’t come back down to near its 2% target until mid-2024. Inflation has slowed recently, but that just means prices are rising less quickly, rather than going into reverse. Energy, food, and the services sector are still seeing substantial price rises[3].

All the while, we’ve experienced several base rate hikes since December 2021, seeing rates hit levels not seen since early 2008[4]. So, if the base rate has been raised so aggressively, why is everything still expensive?

In short, raised rates take time to have an impact. On top of asking how do interest rates affect inflation, property investors should query how quickly it takes for raised rates to make a difference.

It can take up to nearly two years to see prices react to hiked rates[5]. Also, what’s pushing prices higher at the moment is largely outside of the BoE’s control. Food costs and energy bills have been primary drivers of inflation in recent months. This is largely the result of Russia’s invasion of Ukraine, which led to economic sanctions, and supply chain bottlenecks.

Also, central bankers across the world faced criticism from the world of commerce, the public, and governments over the last few years. As inflation started to rise following the pandemic years, central banks labelled rising costs “transitory[6]”. Despite calls for rate hikes to tame inflation, the BoE and other central banks refused to do so for a long time.

By the time central bankers acknowledged inflation was here to stay and started to raise rates, some argued it may have been too late. The damage was done, and delayed hikes would have little effect. Nevertheless, higher interest rates are here and regardless of whether they tame inflation over the long-term, they have an impact on our day-to-day.

How do interest rates affect inflation and investor’s finances day-to-day?

Raised rates tend to have an immediate impact on certain financial products. Chiefly, this concerns bank accounts, mortgages, and consumer credit services. For mortgage owners, repayments tend to become more expensive.

While exact costs will vary between borrowers, analysis from UK Finance[7] found that when taking all consecutive base rate rises into account (up to August 2023), average monthly payments rose by £488.50 for tracker deals. Also, assuming base rate rises were fully passed on, standard variable rate mortgages will have risen by £311.90. Yearly, this equates to £5,862 and £3,742.80 respectively.

Of course, higher rates have an impact on demand within the property market. If borrowing costs rise substantially, would-be buyers become hesitant to act. Adding to these difficulties is that some high street banks, arguably, haven’t been acting as they should in the face of rising rates according to some.

The government, regulators, and wider press have criticized the big banks for being quick to pass base rate hikes onto mortgage holders, but failing to do the same for savers[8]. What’s more, mortgage costs are actually rising in the market, despite recent base rate cuts[9].

We need to focus on the long-term

To overcome our inflationary challenges, all of us – regulators, central banks, and private companies – need to come together. Long-term inflation has long-term consequences. Our collective purchasing power plummets, the economy risks falling into recession, and more drastic measures are needed.

Fortunately, there are signs of recovery in the UK economy. Andrew Bailey, the Governor of the BoE, recently confirmed he expects four base rate cuts in 2025, so long as inflation continues to ease[10]. Indeed, inflation in the UK is forecast to stick around the 2%[11] mark for the next five years or so, which may encourage to keep the base rate at a more affordable level.

This could time particularly well for property investors. Average house prices could rise by 23.4% over the next five years, according to the latest forecast from Savills[12].

To get ahead of this, borrowers will want to work with a lender that remains flexible in any economic circumstance, and who can move quickly in the face of rising demand. We can provide those borrowers with said flexibility and speed. We’re ready to hear from brokers and their clients.