How do interest rates affect inflation and what does it all mean for the economy?

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how interest rates impact inflation

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, by raising interest rates, inflation should slow down. And when rates are low, inflation is set to rise. When rates rise, 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. 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?

Source: Bank of England, The Times

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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 is currently sitting at 6.8%. While it has been slowing in recent months, inflation is still well above the BoE’s 2% target.

All the while, we’ve experienced 14 consecutive base rate hikes since December 2021, raising rates to levels not seen since early 2008. 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, you should query how quickly it takes for raised rates to make a difference.

It can take up to two years to see prices react to hiked rates. 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”. 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 argue 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.

Source: ONS, The Independent, Bank of England, House of Commons Library, Financial Times, Reuters

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How do interest rates affect inflation and your 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 found that when taking all 14 base rate rises into account, average monthly payments will have risen by £488.50 for tracker deals. Also, assuming base rate rises have been 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 Chancellor, 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. The FCA recently announced it would name and shame banks that short-changed their customers after finding less than 30% of interest rate rises were passed on to savers.

Source: The Independent, The Telegraph

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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, cast doubt on the need for further interest rate rises at a recent Treasury Select Committee meeting. And even if rates continue to rise, many expect a peak around the 6% mark in 2024, which may then fall to around 3% by 2026.

Also, inflation is finally starting to slow down. Jeremy Hunt, our current Chancellor, said he was confident that the CPI is still on track to halve by the end of 2023. If we continue on the right economic path, better days may be their way. House prices may continue to lag next year, but many commentators believe we could see a rebound as we head into 2025.

This means the window of opportunity to invest in property at a discount may be closing. For investors, now may be the time to act to bag a bargain as the economy displays the early signs of recovery.

To get ahead of this, you’ll 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 you with said flexibility and speed. We’re ready to hear from you.

Source: Financial Times, Financial Times, This is Money, Sky News

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