With rising fears of inflation and the increasing cost of living, there is pressure on central banks – including the Bank of England – to raise interest rates in response.
Interest rates have been at close to rock-bottom levels since the global financial crisis of 2008, and were lowered again in response to the coronavirus pandemic. But the recent increase in inflation has led central banks to take an increasingly hawkish stance.
Of course, all this might seem a bit abstract – so what exactly are interest rates and, more importantly, how do they affect you?
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What are interest rates?
Interest rates are, in short, the cost of borrowing – or, if you’re a saver, the amount of interest that’ll be added to your savings.
As a result, even relatively modest adjustments to interest rates can have a significant effect on your overall living standards.
What is the bank rate?
Bank Rate – also known as the base rate – is the rate at which high street banks can borrow money from the Bank of England. It is the most important interest rate in the UK.
Because the base rate determines how expensive it is for other banks to borrow from the central bank, it also affects ordinary consumers’ borrowing costs as well.
A lower bank rate means it’s cheaper for high street banks to borrow, and hence also for consumers to borrow money from those banks (in the form of mortgages and other loans).
However, a higher bank rate makes it more expensive for banks to borrow – and therefore consumers’ borrowing costs will also go up as well.
Will interest rates go up in 2022?
Interest rates are expected to increase in 2022, as central banks including the Bank of England look to combat the rising rate of inflation.
The Bank of England increased its base rate from 0.1% to 0.25% in December 2021, in a move which surprised many observers.
It is expected that the BoE will raise its bank rate further in the coming months, in an attempt to curb inflationary pressures in the economy.
How do interest rates affect inflation?
Higher interest rates make it more expensive for banks – and hence ordinary households and businesses – to borrow money which they would otherwise put into the economy.
Increasing borrowing costs therefore curbs economic activity, which – so the theory goes – helps to stymie inflationary pressures.
However, raising interest rates doesn’t always work in curbing inflation. The recent increase in inflation has been largely driven by supply chain blockages, and some are skeptical of the idea that higher interest rates will do much to curb this sort of inflation.
How do interest rates affect house prices?
Interest rates, by affecting how much it costs for would-be buyers to borrow money, can have a significant impact on house prices.
Higher interest rates make borrowing more expensive, so may deter buyers from entering the housing market. They may feel it’s better to hang on for a while and wait for borrowing costs to fall again, so may decide not to buy a house.
Lower interest rates, by contrast, make borrowing cheaper – so can stimulate more activity in the housing market.
Interest rates were radically lowered after the 2008 global financial crisis in an effort to prevent a house price crash, as well as encouraging businesses to borrow and invest.
So, higher interest rates may cause house price growth to slow, or even – in some circumstances – cause prices to fall.
Although interest rates look likely to increase in the months ahead, they still remain very low by historical standards, so any effect on the UK housing market is likely to be quite modest.
How do interest rates affect businesses?
Higher interest rates make it more expensive for businesses to borrow, so tend to depress investment in the economy as a whole.
This is an intentional outcome. Central banks looking to curb inflation are trying to restrain business investment so that overall economic activity calms down and inflationary pressures are eased.
By contrast, lower interest rates make it cheaper for businesses to borrow, which helps to stimulate more economic activity.
In the event of an economic downturn, central banks may therefore cut interest rates so that businesses feel encouraged to borrow and invest money, boosting the economy as a whole.
What happens when interest rates rise?
When interest rates rise, borrowing becomes more expensive. This may lead consumers to put off major purchases, and convince businesses to cancel or defer planned investments.
Higher interest rates also make saving more rewarding, by providing savers with increased interest on their savings. This may result in increased future consumption, but is unlikely to offset the economic impact of increased borrowing costs in the short term.
Increased borrowing costs may also affect the housing market by deterring people from buying houses, dampening down house price growth.
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