Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
We often hear about interest rates and inflation in the news, but it’s not always obvious what they really mean or how they affect us. Here we take a closer look at what they are, how they interact, and why their usual relationship isn’t quite playing out in the way we’d expect right now.
What is inflation?
Inflation is basically the rise in the price of goods and services over time. Put simply, it means your money doesn’t stretch as far as it used to. If inflation is running at 5%, something that cost £100 last year will cost £105 now.
The Consumer Prices Index, or CPI, is the measure of inflation you’ll most often hear mentioned in the news. That’s because it’s considered the headline rate - the one the government, the Bank of England and most economists use when they talk about how fast prices are rising. The CPI includes a wide ‘basket’ of everyday goods and services, from food and clothes to transport and energy bills, which means it’s a pretty good reflection of the kind of everyday prices we come across.
What are interest rates?
Interest rates are essentially the cost of borrowing money. In the UK the benchmark is set by the Bank of England - known as the base rate. It acts as a guide for how much it costs banks to borrow money.
High street banks and lenders then use that base rate to set their own rates for mortgages, loans, credit cards and savings accounts. So, when the base rate goes up, borrowing usually becomes more expensive and saving more rewarding.
The exact rates you see as a customer are decided by individual banks, but they almost always move in the same direction as the base rate - it’s just a question of by how much.
How do interest rates and inflation work together?
The Bank of England uses the base rate as its main tool to keep inflation under control. When inflation is high, it raises the base rate. This makes it more expensive for banks to borrow money, and in turn they pass on higher costs to households and businesses through mortgages, loans and credit cards. At the same time, banks usually increase the interest they pay on savings, which gives people an incentive to save rather than spend. Together, these changes are meant to slow down spending in the economy and bring price rises under control.
When inflation is low, the opposite applies. The Bank cuts the base rate, making borrowing cheaper and saving less attractive, which encourages people and businesses to spend more and support economic growth.
Inflation rates and interest rates: the 10-year chart
Inflation (the blue line) really began to surge in 2021, driven first by the aftermath of the pandemic. As economies reopened, global supply chains struggled to keep up with demand, pushing up the cost of goods and raw materials.
Then, in early 2022, Russia’s invasion of Ukraine sent energy and food prices soaring worldwide. These global shocks, well beyond the reach of UK interest rates, explain why inflation spiked so sharply and why raising rates at home didn’t immediately bring it back under control.
This is why you see inflation surging ahead of interest rates on the chart - and why it took time for policy decisions to take hold and start bringing it back down.
So, why aren’t interest rates cooling inflation as much as we’d expect?
While the Bank of England can influence inflation with rate changes, the link isn’t always direct and there can be a lag between the two. Right now, the Bank is gradually reducing rates because inflation has fallen a long way from the high of 11.1% seen in 2022. But on a shorter time-frame inflation has been ticking higher, rising to 3.8% in July having dipped as low as 1.7% last September. Much of this recent rise has been expected by the Bank, so it has not seen the need to divert from its rate-cutting plan. Were inflation to rise much further, however, that could change.
There are other reasons why rate changes have only a limited effect on inflation. Inflation that is driven by global price shocks - from energy and food to supply chains is beyond the control of the Bank.
At the same time, the impact of higher rates on households has been weaker than in the past. Many families built up savings during the pandemic, which gave them a cushion against rising prices. And many mortgage holders are still on fixed-rate deals, meaning they haven’t yet felt the full effect of higher borrowing costs. Together, these factors blunted the immediate squeeze that rising interest rates would normally create.
Wages have also played a part. As prices rose, workers pushed for higher pay to keep up with the cost of living, and employers facing staff shortages agreed to bigger increases. While that helped households manage their money, it also gave people more spending power and pushed business costs higher, feeding into further price rises. Economists call this ‘sticky’ inflation because it doesn’t ease as quickly as energy or commodity prices.
Finally, there’s the natural lag. It often takes a year or more for rate rises to fully work through the economy. That delay, combined with government support schemes such as the Energy Price Guarantee, has meant inflation has come down more slowly than expected.
Together, these factors help explain why higher interest rates aren’t working as effectively as they once did in bringing inflation under control. For savers and borrowers alike, understanding this relationship matters - because it shapes everything from mortgage repayments to the value of money sitting in a savings account.
If you’ve got a burning question you want to ask, why not drop us a line? Ask us your question.
Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Eligibility to invest in an ISA and tax treatment depends on personal circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of financial adviser or an authorised financial adviser of your choice.
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