Inflation. No matter where you are, it seems like this word is on the tip of everyone’s tongue. The UK, like most countries, has been hit hard by inflation, which reached a 40-year high of 9.1% recently. This figure is high, but the same as other OECD and G7 countries are experiencing. Each one is facing inflation in the 6%-10% range. Unfortunately (or fortunately, depending on how you want to look at it), the Bank of England interest rates will rise dramatically as it tries to combat inflation.
As a consumer, you’re probably wondering, “how will all this affect me?” Glad you asked! It will affect you significantly, and in ways you might not anticipate. To understand how these rate increases will affect you, it’s first essential to know how inflation works and how interest rates combat it.
What Is Inflation?
Inflation is the increase in the price consumers pay for goods and services. If you used to pay £2 for eggs at the local store, and now you pay £2.20 at the same store, the inflation rate would be 10% on those eggs.
The Government cannot measure every single item at every single store. So, they measure and track the price of a core set of staple goods and services representative of what average consumers buy. This index, called the Consumer Price Index (CPI), typically includes food items, energy (including electricity and petrol), housing costs, recreational costs, and many more things across various categories. Those interested in what, exactly, this index includes can read the detailed list on the Office for National Statistics.
Some prices might go up, and some might even go down. However, the average is what the Government uses for the metric that it reports. So, if you hear that inflation has increased by 9%, the CPI has risen by that amount, which should represent what the average consumer feels.
Why Is Inflation Bad?
Inflation in and of itself is not bad. Quite the opposite – a healthy economy has a modest increase in the price of goods and services each year. The Government typically targets 2% inflation annually.
Modest inflation encourages spending (if prices will rise slowly in the future, it helps customers want to spend money now) and makes previous debt easier to service. It also shows a healthy demand for products and services, as they become more expensive because consumers want them.
When inflation skyrockets, that causes problems for consumers. Wages tend not to keep up as quickly with inflation, which means less purchasing power. Furthermore, skyrocketing inflation can have the opposite effect on purchasing desire – while moderate inflation encourages spending, soaring inflation can decrease spending because consumers are fearful and wages haven’t caught up. Additionally, severe inflation can be a symptom of a supply-side bottleneck, with too many pounds chasing too few goods and services.
2% inflation is excellent, but 9% inflation is problematic for the economy!
How Do Bank of England Interest Rates Fight Inflation?
With a solid grasp of what inflation is and why high inflation is bad, the question is, what do Bank of England interest rates have to do with the cost of goods and services? More specifically, how do these increases in the Bank of England interest rates lower inflation?
The short answer is that when the Bank of England interest rates rise, interest rates across the country rise. Rising interest rates make money (credit) more costly. Without as much purchasing power and the cost of money itself becoming more expensive, there’s less money chasing the goods and services, pushing prices downward.
In a way, you can think of it like this: as there’s inflation in the cost of borrowing money itself, there’s less in the system, leading to lower prices overall.
The Longer Answer
The longer answer to this question goes deeper into the UK banking system. The Bank rate is the rate the Bank of England will pay on deposits from commercial banks. So, when Barclays, for example, wants to put £1 million into the Bank, if the rate is 1%, they’ll earn 1% interest on that £1 million. Since it’s the UK’s central bank, it’s safe and presents zero risk to the financial institution.
Therefore, in this example, you can think of the Bank rate as the “guaranteed profit” rate for Barclays. Barclays can always store their money and make 1% on it.
If they are going to make a more risky investment and lend it to, say, John, who is looking to buy a house in London, they would need a premium over that very safe 1%. That is, they’d need at least the Bank rate plus some extra to represent the risk the bank is taking. Perhaps the rate would be 3%, 1% from the Bank of England, and 2% from the additional risk the bank is taking by lending to John.
If, however, the Bank raises its rates to 2%, then the mortgage rate for John would be 4%. There’s still the 2% risk premium, but since the bank could make 2% guaranteed now, they’d add the 2% risk to that new guaranteed rate.
A mortgage at 4% means John has less money at his disposal. It also means fewer loans can get done (since the payments are higher), which means less money in the system. Since money is more expensive, inflation goes down!
What Are the Target Bank of England Interest Rates? How High Can They Go?
For anyone who has recently entered the workforce, their only memory is of the recent decade or so, which has seen unprecedented low interest rates.
As of July 1, 2022, the rate is 1.25%. Economists predict that the Bank may go as high as 2.5% within a year. However, this is far below the historical average. Indeed, the average Bank of England rate is about 4.6%. The Bank would have to raise its rates considerably to reach where they have been historically.
With inflation at 40-year highs, it’s not inconceivable that the Bank will have to raise interest rates even higher than that 2.5% to get inflation back to the 2% goal the Government has.
The target is 2.5%, but as for how high rates could go (in theory), it was just in 1979, less than 50 years ago, that the base rate was a whopping 17%! If inflationary pressures don’t subside, it’s not inconceivable that we could have some incredibly high rates in the future!
Bank of England Interest Rates: What Does This All Mean for You?
Practically, interest rates rising has a whole slew of effects on the economy.
For the average consumer, the cost of credit is about to become much higher. Expect to see mortgage rates go up, credit card rates rise, and even auto loan rates become higher. The higher rates will also drive the cost of borrowing up for companies, leading to potentially higher prices in the short term.
If you have debts that the increase in rates could affect (like variable-rate mortgages), now is the time to start looking at how you can afford the payment increases or if there is a way you can switch to a fixed-rate product. A fixed-rate 5-year term mortgage could save you some money if the Bank of England raises rates aggressively in the short term. Pay down any credit card debts, too, as those rates will increase with the Bank rate increases.
If you are thinking of buying a home or car, now is probably the time to lock in a loan. If rates ever went up to 5%, 10%, or hit records again at 17%, buying any of these could be prohibitively expensive. You might want to consider getting a move on financing any large purchases.
High Bank rates also make equities less attractive for investing. If a stock returns 7% per year on average, and the Bank is willing to give the bank 5% guaranteed, it will probably take the guaranteed money instead of putting it into equities, like stocks. Conversely, the bond market becomes more attractive as rising rates increase bank deposit rates, which means bond rates have to rise to compensate (i.e., give the same risk premium over the surety of a bank deposit).
Therefore, in terms of investments, you may see equities going down in price while bonds continue an upward march.
Bank of England Interest Rates: Changes Are Coming
Ultimately, the Bank of England is serious about fighting inflation. The biggest tool it has is to keep raising its benchmark rate. It will do so until inflation returns to the more stable 2%-ish per year. These rate increases will likely make debts more expensive, equities cheaper, and ensure bonds have higher yields.
It’s becoming increasingly clear that the era of record-low interest rates is closing. The good news is that rates are still below their historical averages, even if it may shock people who weren’t aware of these rates in the 70s, 80s, and 90s. The bad news is that the increased interest rates will pressure consumers and corporations.
Changes are coming, for sure, but as history has shown, high interest rates don’t last forever. With careful planning, you’ll be able to withstand them and come out in better financial shape on the other end!
