The Bank of England is expected to increase interest rates by 0.5%.
(Picture: AFP via Getty Images)The Bank of England is expected to make history today by raising interest rates by half a percentage point.
Such a significant increase has never been done before by the Monetary Policy Committee (MPC), with previous rises made in quarter percentage point increments.
However, both the US Federal Reserve and the European Central Bank (ECB) have made similar decisions recently in attempts to curb the rising rates of inflation around the world.
Here’s a look at how raising interest rates can help to lower inflation and what kind of effects we can expect to see.
How do interest rates affect inflation?
The interest rate set by the Bank of England, known as the base rate, affects how much mortgages and loans are and how much interest people can make on their savings.
The higher the rate of interest on borrowing, the more consumers pay on loans and the less they make from saving.
In general, raising interest rates makes purchasing goods and services more expensive for both consumers and businesses.
For example, the expected increase from the Bank of England today could see half a million London homeowners pay hundreds of pounds more in monthly mortgage repayments down the line as mortgage rates increase.
With borrowing and spending made less attractive, people tend to purchase less, reducing demand for goods and services across the market. As demand drops, prices usually fall as well, helping to lower inflation over time.
Conversely, when interest rates are low, inflation tends to rise.
Looking back to December 2021, inflation was at a record low. People felt confident to spend more and save less, with low interest rates meaning saving money held little benefit.
Now, with the Bank of England raising interest rates, consumers will likely have a renewed interest in saving and therefore spend less.
With less demand for goods, prices should stay the same or even be forced to drop, as retailers and businesses encourage consumers to continue spending.
As many households across the UK struggle to keep up with rising costs of everyday essentials like food, fuel, and energy bills, price decreases would be a welcome change.
How long will interest rates stay high?
While raising interest rates can be helpful in reducing inflation, it usually takes 12 months to see the effects of such changes in the economy.
The Bank of England has previously confirmed that it expects inflation to hit yet another record high of 11% in the coming months.
Rising inflation has sparked a flurry of unprecedented interest rate hikes over the last few months, resulting in a 1.15 percentage point increase since December 2021.
There are concerns among market experts that raising interest rates will not be enough to counteract the price hikes affecting inflation, with unemployment rates reminiscent of the 1970s inflation increase, which resulted in a post-war inflation high of 25%.
With the Bank of England expecting inflation to continue to rise over the next few months, it’s possible this won’t be the end of the interest rate increases.
It’s important to remember that interest rates aren’t the only element affecting inflation.
Major world events can also affect inflation. In the 1970s, the oil crisis sparked the inflation rise. Today, the combined effects of the Russia-Ukraine conflict, Brexit, and the lasting damage from the pandemic are all influencing demand and therefore inflation.
Regardless, we can expect to see the current rates stay as they are or increase for likely another year or so until the effects on the economy are revealed.
