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

The cost of living crisis delivered yet another nasty surprise in March, with the news that inflation had risen unexpectedly in February to 10.4%.

While below the record rate of 11.1% seen in October 2022, it still means price rises are increasing so rapidly that the purchasing power of the pounds in our pockets is being eroded at an alarming rate. New research by charity the Food Foundation showing key workers are struggling to afford to eat underlines the severity of the situation.

In a bid to bring inflation back to a more sustainable level, the Bank of England has increased its base rate 11 times since the start of 2022. The latest increase saw rates climb another quarter of a percentage point to 4.25% on Thursday (23 March).

This move will theoretically bring inflation down, with current projections suggesting price rises will tail off as we get towards then end of 2023 - possibly to as little as 2.9%. Mortgages, and the cost of borrowing money more generally, are likely to go up as a result.

This situation comes as the UK economy remains in a fragile state with a reversal likely over the course of the year - albeit without a technical recession occurring. There are also concerns about the health of the banking system in the wake of the failures of Silicon Valley Bank and Credit Suisse.

So, why is the Bank of England hiking interest rates - and what does a hike mean for inflation?

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.

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, hitting a 41-year high of 11.1% in October 2022. 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.

But the headline rate of inflation has come down since this high was recorded, and now sits at 10.4%. While the rate of price increases is coming down, it still means products are rapidly becoming much more expensive.

While the government claims it is working towards cutting inflation by half this year, the issue is largely out of its control. In fact, Rishi Sunak’s government played its biggest card when it announced a significant increase in the UK tax burden in the Autumn Statement.

The problem facing economists at the Bank of England is when to stop hiking interest rates. Analysts and business groups have warned continuing hikes will make any UK economic downturn worse - something that could also deepen the cost of living crisis as economic reversals can lead to greater unemployment.

But the central bank has struck a more positive tone in its forecasts for the UK economy. It says it will now grow marginally (by 0.3%) over the next three months rather than decline by 0.4% as it predicted in February.

This matters when it comes to the cost of living because a growing economy means people’s disposable incomes have more chance to rise, and workers are more likely to keep their jobs. Businesses reduce their staff headcounts in economic downturns because it becomes harder for them to afford to fund their operations. Not only is this bad for economic growth, but it also reduces the amount the government can raise in taxes.