Interactive Investor

What you need to know about interest rates

16th June 2022 13:02

Alice Guy from interactive investor

Alice Guy explains how the Bank of England base rate works, how interest rates affect the economy and how they impact your borrowing costs.

With inflation running hot, the Bank of England base rate is in the spotlight, and several interest rate rises are expected over the next few months to try and bring rising costs under control.

In theory, raising the base rate can reign in galloping inflation, but on the downside, raising rates could also have a dampening effect on the economic outlook.

Here we take a look at what you need to know about interest rates, how the Bank of England sets the base rate, how interest rates affect the economy and what a rise in rates could mean for your finances.

What is the Bank of England base rate?

The Bank of England (BOE) base rate is the interest rate the bank charges the government and other lenders when they borrow money.

The rate affects how much other lenders charge each other and many flexible rate mortgages fluctuate in line with the base rate.

How does the Bank of England set interest rates?

The Bank of England Monetary Policy Committee (MPC) meets eight times a year to discuss and decide on the base rate.

The members make their decision after considering a variety of factors including the rate of inflation, the growth of the economy and the likelihood of a recession.

After their discussion, the MPC’s nine members vote, and a majority decision is made on the base rate.

By the time, the rate rise is announced, it’s usually reflected or “baked into” share prices. That’s because the announcement is the subject of much public discussion and is often expected by the time it is announced. Like other economic news, the only time the announcement really affects share prices is when the decision is unexpected.

How do interest rates affect the economy?

Along with other factors, interest rates can have a big effect on the economy.

Lower rates make it cheaper to borrow, encouraging people and businesses to spend more, which helps stimulate the economy. But a long period of low rates can also contribute to spiralling inflation.

In theory, if the Bank of England increases rates, this can help to bring inflation under control. The problem is that increasing rates too high or too quickly can also suppress the economy and lead to a period of recession.

How does the base rate affect my borrowing costs?

The base rate affects the cost of borrowing for banks and building societies, so it has a knock-on effect on consumer borrowing costs.

In the UK, most mortgage holders choose a fixed-rate mortgage, and those fixed rates don’t directly link to the base rate. Mortgage lenders decide their rates based on long-term estimates of likely interest rates, so an expected upward trend in rates is likely to affect mortgage rates on offer.

If you’re a tenant, you may also be indirectly affected as rising mortgage rates tend to push up average rental costs.

Why are interest rates so low?

Interest rates are currently at a historic low. In fact, 2009 was the first time rates had dropped below 2% in the last 300 years, since the Bank of England started setting interest rates in 1694.

The current period of ultra-low interest rates is actually a hangover from the 2008 financial crash and the result of long-term attempts to stimulate a lacklustre economy. However, this long period of low rates is now partly responsible for galloping interest rates.

How high will rates go?

So, are we likely to return to the extremely high interest rates of the 1970s and 1980s? Are we going to see interest rates reach anywhere close to their peak of 17% in 1979: the year Margaret Thatcher came to power?

Actually, those very high interest rates are also very unusual. Since 1694, interest rates have usually hovered between 3% and 6%, and only hit double figures for the first time in 1973.

This period of high interest rates was largely an attempt to control a long period of high inflation that lasted from 1972 to 1982. In the mid-70s there were four successive years of double-digit inflation, with a peak of 24.2% in 1975.

As for today, most economists predict that high inflation will be short-lived and only last one or two years. If they’re correct, then interest rates will need to rise, but are unlikely to climb higher than 2% to 3%, at least for the next few years.

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