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

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

The Bank of England has hiked interest rates again as the UK continues to battle its worst inflation crisis since the 1970s.

It has increased its base rate from 4.5% to 5%, which means it now sits at its highest level since the peak of the 2008 financial crisis 14 years ago. The rate increase means more pain is in the offing for mortgage payers and those in debt, although it should bring about an improvement in savings rates.

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It comes as the cost of living has soared over the last 12 months as the level of price rises (i.e. the rate at which our spending power is being reduced) has hit a four-decade high. Even though the official measure we use to define inflation - the Consumer Prices Index (CPI) - has reduced to 8.7% from the 11.1% seen last October, it has not gone down as quickly as economists had hoped.

In a bid to lower the rate of inflation, the UK central bank has now increased its base rate 13 times since December 2021. But this activity has added hundreds of pounds to monthly mortgage repayments, with the latest decision likely to mean some borrowers have to shell out even more. This situation has also coincided with a fragile UK economy.

So, why has the Bank of England been hiking interest rates - and how exactly does the base rate affect inflation? Here’s what you need to know.

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 in order to maintain the value of their initial loan - something that is directly influenced by the UK central bank’s base rate.

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Given the UK has a target of keeping inflation 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. By using the Bank of England’s inflation calculator, you can see the impact of inflation yourself. For example, £1 in 1993 was worth £2.01 as of March 2023 - the most recent month for which we have inflation data.


To keep inflation as close to 2% as possible, the Bank of England - whose primary role is to safeguard the UK’s currency - raises and lowers the base rate accordingly. Its Monetary Policy Committee (MPC), a group of senior economists from within the central bank and the City of London, meets eight times a year to look at the economy and decide the rate it will set. The latest such meeting took place on 10 May, with the results announced a day later.

How do interest rates affect inflation?

Interest rates have a direct impact on inflation. 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 spending can take place across the economy. Generally, businesses are less likely to take out loans, which they use to invest in expansion, while housing market activity slows because mortgages get 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 struggle to grow; lower them by too much and inflation could rocket. The biggest real-world impact the latest decision could have is that it may lead to a housing market crash given it will push mortgages out of the price range of most prospective buyers.

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There are also concerns from some quarters of the economist community that the rate hikes may only serve to increase inflation. Economic justice campaigner Richard Murphy has argued that higher borrowing costs are translating into higher prices for loan-based goods and services, like car leasing, and that businesses are likely to be passing on their higher interest burden to their customers.

On top of this, interest rates do not impact as much of the country as they used to given fewer people have a mortgage, and most of those that do are on fixed rates. Fixed rates shield people from interest rate hikes, diminishing their power to restrict the general public’s spending.

What does interest rate rise mean for cost of living?

Inflation hit a 41-year high of 11.1% in October 2022 but has since declined to a rate of 8.7%. Although this latest figure is well below the inflationary peak, it still means prices are rising.

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

Meanwhile, hiking interest rates makes mortgages more expensive. Borrowers on variable rate and tracker rate products will see an immediate hike in their bills, while people on fixed rates will be exposed to the higher rates over time.

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But, arguably the biggest cost of living impact comes from the market’s impression of the Bank of England’s plan to use interest rates to quash inflation. The combination of the central bank’s failure to accurately predict inflation’s direction of travel for four consecutive months, as well as the actual figures in themselves, have served to reduce market confidence in the Bank of England. These issues have already sent mortgage rates soaring, and have even seen some lenders pulling their deals from the market at short notice.

On top of this, the higher mortgage rates go - and the higher the Bank of England base rate goes - the greater the risk of a recession. These economic events tend to have a bad impact on living standards given people are more likely to be made unemployed. However, economists and politicians are talking a recession up as a possible way to end the inflation crisis.

JP Morgan’s Karen Ward told the BBC on Wednesday that the Bank of England must “create uncertainty and frailty, because it’s only when companies feel nervous about the future that they will think ‘Well, maybe I won’t put through that price rise’, or workers, when they’re a little bit less confident about their job, think ‘Oh, I won’t push my boss for that higher pay’. It’s that weakness in activity which eventually gets rid of inflation.”

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