How do rising interest rates contribute to inflation? What the Bank of England’s new rate means for UK inflation
Mortgage prices could rise after the Bank of England raised the base rate from 2.25% to 3%.
This is the latest in a series of base rate increases, which means some people will see their mortgages increase by hundreds of pounds compared to last year.
The bank did this in an attempt to combat runaway inflation, as the current rate is over 10%.
At a press conference after the rate decision, Andrew Bailey said things would get worse for all Britons if the Bank did not raise interest rates.
“We understand the difficulties of the situation we find ourselves in and the difficulties facing mortgage holders,” he said.
“If we don’t act to bring down inflation, things will get worse.”
The Governor of the Bank of England said there was “no easy outcome to this”.
But how will this help inflation? Here’s everything you need to know.
What is Inflation?
Inflation is a measure used to explain how much the prices of basic necessities have increased.
It can be used to measure the daily, monthly, or annual increase in prices, as well as to compare today’s prices with those of decades or even centuries ago.
Why do interest rates tend to rise with inflation?
The Bank of England (BoE) raised its interest rates to 3%, this increase aimed at curbing inflation.
Rising interest rates make borrowing more expensive and may encourage more people to save.
This means that people tend to be more careful when spending money, which reduces the demand for goods and services, which in turn lowers their prices. Conversely, the more people spend and the more demand increases, the more retailers and suppliers increase the price of things.
So, when interest rates are low, inflation tends to rise, and when rates are high, inflation generally falls.
With interest rates at historically low levels in recent years, inflation has been able to soar unhindered.
How do interest rates affect mortgage rates?
Although the BoE’s move is intended to temper price increases, it will add pressure on already strained households as mortgage rates rise.
UK interest rates are set by the BoE’s Monetary Policy Committee (MPC). It does this by setting the BoE base rate – the interest rate at which banks borrow from the BoE.
This, in turn, affects the interest rate that banks charge mortgage borrowers – also known as the annual percentage rate or APR.
Due to rising interest rates, trailing mortgage rates are increasing and fixed mortgage rates are increasing for new applicants and repayers.
This means many struggle to find good deals unless they can set their rates.
UK homeowners have enjoyed a prolonged period of low mortgage rates since the 2008 financial crisis as the Bank of England kept its base rate low in a bid to encourage economic growth.
The Bank of England base rate is the rate the central bank charges other banks and lenders when they borrow money. It therefore influences the interest rate of lenders for mortgage loans.
After more than a decade of low interest rates, the Bank of England began steadily raising the base rate from December last year in a bid to tackle soaring inflation.
Interest rates on all types of mortgages have risen alongside the base rate, but this process has been accelerated following former Chancellor Kwasi Kwarteng’s mini budget. Unfunded tax cut plans spooked financial markets and forced lenders to raise interest rates, fearing the policies would further fuel inflation.
For those with a follow-on mortgage, UK Finance predicts the average monthly payment will increase by £73.49 per month (£880 per year), while the average repayment on a standard variable rate mortgage will increase by £46. £.22 per month (£554.64 per year).
How does inflation affect pensions and savings?
Higher inflation rates can affect the value of your pension. If your pension increases by a fixed amount but inflation is higher, its value may actually decrease.
However, state pensioners could receive 10% more payments next year to keep pace with inflation as the government returns to the triple lockdown system.
Interest rate increases can be positive for savers, and the rates available on the savings account should increase, at least marginally, although they will remain at historically low levels.
However, any increase will not be enough to counter the eroding effect that inflation has on the value of cash.
Savers with cash savings accounts will suffer a loss in real terms because the rate of inflation will be higher than the rate of return on their account.