How do UK interest rates affect inflation? Bank of England base rate explained, impact on cost of living

Interest rates affect everything from mortgages to economic growth, with the Bank of England forced to raise them in a bid to counter record inflation

The UK cost of living crisis has reached a grim new high, after the Office for National Statistics (ONS) recorded an 11.1% rise on the October 2022 CPI.

The highest rate for 41-years, it means average prices across the UK economy are rising while the purchasing power of the pounds in our pockets is diminishing. This new peak of inflation has also come at a time when people are being squeezed by higher unemployment and a real-terms drop in wages.

In a bid to bring inflation back to a more sustainable level, the Bank of England announced another UK interest rate rise on 3 November. It hiked its base rate by 0.75 percentage-points to 3% - the largest single rise since 1989.

While it should bring inflation down over the next six months, this rate of interest means mortgages, and the cost of borrowing money more generally, will remain inflated for some time. This situation comes as the UK economy is already expected to face a squeeze in the form of a major recession.

It all means more financial pain is still to come for under-pressure households across the country. So, why is the Bank of England hiking interest rates - and what does a hike mean for inflation?

The Bank of England base rate has had its single biggest increase since 1989 (image: AFP/Getty Images)

What is the Bank of England base rate?

The Bank of England base rate determines how much it costs to borrow money in the UK.

When you take out a mortgage or a loan, the lender will add interest. Some of this interest will be determined by how risky they deem the borrower to be, but much of it will be influenced by how much the lender needs to earn back to maintain the value of their initial loan - something that is directly influenced by the UK central bank’s base rate.

Given the UK has a target of keeping inflation (i.e. the decline in the purchasing power of the pound) to 2% - a percentage that economists believe helps to maintain a healthy level of supply and demand in the economy - the pounds in our pockets are always losing at least some of their value.

Governor of the Bank of England Andrew Bailey sits on the Bank of England MPC (image: Getty Images)

To keep inflation as close to this level as possible, the Bank of England - whose primary role is to look after the UK’s currency - raises and lowers the base rate accordingly.

Its Monetary Policy Committee (MPC), a group of senior economists from within the bank and the City of London, meets several times a year to look at the economy and decide the rate it will set.

How do interest rates affect inflation?

Interest rates and inflation have a direct relationship. When interest rates go up, inflation goes down - and vice versa.

The reason for this is that when money becomes more expensive to borrow, it restricts how much economic activity (i.e. spending) takes place. Businesses are less likely to take out loans they might use to invest in expansion, while housing market activity slows down because mortgages become more expensive.

At the same time, it becomes more lucrative to save money, which also reduces spending. It all means the Bank of England has to carefully consider how much to raise interest rates by - raise them too much and the UK could slip into a recession; lower them by too much and inflation could rocket.

What does interest rate rise mean for cost of living?

Inflation has reached record highs in recent months, with the latest data from October showing it now sits at a 41-year high of 11.1%. Energy bills were the main contributor to the percentage-point rise in the rate, despite Liz Truss’s energy price guarantee shielding consumers from the worst wholesale gas and electricity hikes.

Food prices have also continued to soar, and now sit at their highest inflation rate - 16.4% - since September 1977. Everything from milk to cheese and jam has become more expensive, with value items seeing some of the biggest hikes.

In theory, the November interest rate rise should lower this high rate of inflation, but it may be some time before they feed through into shelf prices. The Bank of England predicts inflation will be back below its 2% target by 2025.

Higher interest rates could lead to a slowdown in the housing market (image: AFP/Getty Images)

The key thing to remember is that even if inflation goes down, it still means prices are higher than they were previously and are still increasing. Also, with wages struggling to keep up with inflation and unlikely to catch up for a while yet, it means the cost of living will still be much more expensive than it was last year.

Another big problem at the moment is that the cost of living crisis is just one of the economic issues facing the UK. Most economists believe we’re already in a recession that could last until at least 2024, with the Bank of England saying on 3 November that it could be the longest one on record.

“There is a real risk that – taken together – the Bank raising rates and the government cutting spending are taking too much steam out of the economy,” explains Carsten Jung, senior economist at the IPPR think tank.

“This could mean that in a year’s time we are in deeper economic peril than we need to be, with the Bank forecasting unemployment to almost double over the next years. The Bank should have moved more cautiously and should only gradually raise rates from now on. Crucially, the government should not cut spending, but provide support for the economy while also helping businesses and households with high energy prices.”

When economic growth turns into decline, businesses are more likely to lay off people and wage rises are harder to come by. In turn, this means the government is likely to generate less money through taxes, which can lead to cuts to public services and makes it harder for the government to intervene.

So, while falling inflation is a good thing, don’t expect the cost of living crisis to disappear anytime soon.