The Bank of England has increased its official interest rate from 0.1% in October 2021 to 4% at the time of writing in February 2023. But why have they done this and how does it impact you?
During Covid or any time when the UK economy is struggling, one of the tools used by the Bank of England is to reduce interest rates. The primary driver of this is to reduce the cost of borrowing for households and companies. The theory is that if the cost to borrow money is low, it is more likely that individuals and businesses will borrow and in turn spend that money. If more money is being spent and more goods and services are being consumed, more people will need to be employed to meet the demand, who will then in turn have more money available to then spend on goods and services.
If the demand for further products and services increases quicker than those goods or services can be provided, this will lead to increased prices as both individuals and companies will pay more so that they can be the ones to receive those products and services, this can then lead to inflation. I have written an article all about inflation, and how this impacts you which can be accessed here. If reducing interest rates can increase demand, then increasing interest rates can have the opposite effect in that it reduces demand.
We are currently in a period of high inflation and the Bank of England has used increases in interest rates to try to get this to a more acceptable level, in line with the 2% per annum target. There are many discussions that can be had around the effectiveness of this policy when we still have supply chain issues impacting inflation rather than it being driven by demand, however for today, we are going to look at the theory of why central banks raise rates in periods of high inflation.
If interest rates increase and the cost of borrowing increases, any existing debt held potentially becomes more expensive if it is not a fixed rate. For most individuals, the biggest impact here is on the cost of their mortgage. If the interest rate goes up and there is not a fixed rate product in place, or if the fixed rate product is coming to an end, the cost for that same debt and the monthly payment, is now going to be higher. If income has not increased to match the rise in the cost of debt, then disposable income will be less and none essential spending is likely to be reduced. By reducing an individual’s ability to spend and the attractiveness of borrowing new money, it reduces the demand for goods and services.
Another reason why higher interest rates reduce demand is that the attractiveness of saving money increases, as cash interest rates will usually increase along with central bank rate increases. When rates are low there is little incentive to save surplus in a cash account especially if the interest rate is lower than inflation as your monies purchasing power will be reduced. If demand for products and services drop, prices should also reduce as there is no longer a surplus of people willing to pay more to get the products or service as there was previously.
Increasing interest rates can have significant unwanted consequences. Yes, reducing demand can reduce inflation however, it can also increase the risk of recession (read about what is a recession here). If fewer people or businesses have the ability to spend money, fewer products and services are required as demand reduces, and employers will require less employees. If fewer people are at work, there is less money available for them to spend at a time where potentially the costs of their debt is going up. This can lead to both individuals and companies struggling financially.
As you can see, trying to balance inflation, interest rates, and the economy is not the most enviable job to have.
Managing and planning you’re finances in times of increasing or decreasing interest rates can be challenging and having the advice of a professional could help you plan the right long-term strategy.
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