Households have faced fierce price rises in the past 18 months, with the current rate of inflation (for April 2023) at 8.7% on the CPI measure by the Office for National Statistics (ONS).

However, with inflation so high, why does the Bank of England (BoE) respond with repeated rate hikes? Since inflation began to run away the BoE has been in a process of increasing interest rates. The Bank’s Monetary Policy Committee (MPC) meets most months to decide where it would like rates to be.

Since December 2021 the MPC has hiked the base rate 12 times, the largest hike by 0.75% in November 2022. The current base rate is now 4.5%, having risen from just 0.1% in December 2021.

Inflation game

In order to understand why interest rates are rising, first we have to understand inflation, its causes, and effects.

The government and national statistical authorities measure inflation in order to understand what is happening in the economy. A general goal of the Government is to help grow the economy as measured by gross domestic product (GDP). Although a fairly blunt measure, GDP is the best approximation economists have to tell whether, as a nation, we’re getting wealthier.

When an economy grows prices generally rise with it as people earn more money and spend more on goods and services. Inflation is not a ‘bad’ thing if controlled as it encourages spending, saving (when the interest rates are attractive) and investing. Inflation encourages saving and investing because doing this with your wealth is a good way to maintain or grow its value ahead of inflation.

However, problems can arise when inflation gets too high. This can be caused by an economy growing too quickly – people find themselves with more money and spend it quickly which leads to prices rising faster in response to the increasing demand.

It can also be caused by supply issues. If a company has less of something available to sell, but the same level of demand, it will typically hike the cost as a result – this is the kind of inflation we are largely suffering from now in the wake of the pandemic.

Where interest rates come in

This is where interest rates come into the picture. The UK economy during the 2010s generally lived with very low, stable levels of inflation. In the wake of the financial crisis the BoE cut interest rates to rock bottom in order to make borrowing cheap and encourage the financial system to function correctly. As inflation was so low, it saw little need to hike rates back up to historic levels. However, the inflation which started to rise in 2021 changed this thinking.

Hiking interest rates does two things to an economy.

Firstly, it makes debt more expensive. All debt-related products such as mortgages, loans and credit cards set a level of interest that is ultimately based upon calculations by financial providers who look to the BoE for guidance on a basic level of interest to set. When the BoE hikes its rates, so do these providers, such as banks and other financial institutions. For households, this means more expensive monthly payments on mortgages – if they have a tracker mortgage, more expensive debt servicing on credit cards, and more expensive loans. By doing this, the BoE effectively takes away households’ disposable income, forcing them to spend less on goods and services in the economy, and reining in demand and therefore ultimately, inflation.

The second effect of interest rate hikes is sort of the opposite – it makes saving more attractive. By increasing the base rate, the BoE encourages banks and savings providers to offer better savings rates to customers. By doing this, anyone with money saved up is encouraged not to spend it by better returns offered for leaving the money untouched. While easy-access savings accounts offer a good rate when this happens, the best rates are found in four- or five-year fixed savings accounts or ISAs.

However, this is only theoretical and there is a big issue at the moment which makes this situation look less attractive. With inflation at 8.7%, and the Bank of England base rate at 4.5% – savers, even on the best deals, still won’t find a rate of interest that beats inflation. This means ultimately that even if your money is locked away and earning interest, it is still losing value relative to inflation. As such, it still pays to look at different ways of using your hard-earned money, particularly by investing through the stock market, bonds, and other assets such as gold, property, and others.

In order to make the best decision it is important to consult with a financial adviser to ensure the best outcome and structure possible for your wealth.

Any opinions stated are honestly held but are not guaranteed and should not be relied upon.
The information contained in this document is not to be regarded as an offer to buy or sell, or the solicitation of any offer to buy or sell, any investments or products.
The content of this document is for information only. It is advisable that you discuss your personal financial circumstances with a financial adviser before undertaking any investments.
All the data contained in the communication is believed to be reliable but may be inaccurate or incomplete. Unless otherwise specified all information is produced as of 14th June 2023.