What is the relationship between interest rates and inflation?
image showing petrol pump

What is the relationship between interest rates and inflation?

Over recent months, the Bank of England has increased interest rates significantly – a move mirrored by other central banks, such as the Federal Reserve. With monthly increases since December 2021, interest rates have shot up from record lows to their highest levels since the 2008 global financial crisis.

The central bank has implanted a series of 25 basis point rate increases coupled with some larger 50 basis point ones. This has been part of its strategy to tighten monetary policy and tackle the soaring rate of inflation. As reported by the Office for National Statistics, inflation has rocketed since the end of 2021, taking it way past its target level.

Of course, the higher interest rates resulting from rising inflation have significantly impacted consumers and businesses across the nation. Economists have predicted ongoing base rate hikes at a time when households and businesses are already struggling hugely with energy prices and soaring living costs. However, the BoE and Monetary Policy Committee have said that high inflation last year and moving into this year means they must take aggressive action.

The rate increases resulting from higher inflation mean that the UK economy has been significantly affected – something that could continue through 2023 and beyond.

On the surface, there is an inverse relationship between interest rates and inflation. When interest rates are low, the economy will grow, and inflation will increase. On the flip side, a high-interest rate environment will reduce economic growth, and as a consequence, inflation will fall. However, there are several angles to consider when examining the relationship between interest rates and inflation.

Consumer debt

Consumer spending, much of which is funded by consumer debt, is the fuel that fires inflation. Therefore, it is vital to understand the relationship between interest rates and consumer debt. A report by The Money Charity in December 2021 showed that in October 2021:

  • Average UK household debt stood at £62,965
  • The average credit card debt per household was £2,085
  • Average unsecured debt per adult came in at £3,713
Related article:   European bank shocks observers with huge rate hike

When you consider that funding for interest payments on consumer debt will come from household income, this can significantly impact discretionary spending. This is spending additional to unavoidable living expenses.

Interest rates, consumer debt, and consumer spending

In a low-interest-rate environment, consumer finance such as bank loans, mortgages, and credit cards are more affordable and more easily accessible. Due to the relatively low-interest payments, consumers are tempted to take out new debt facilities and spend. The greater the demand for goods and services, the greater the upward pressure on prices, otherwise known as inflation.

On the flip side, in a high-interest rate environment, interest rates on consumer finance would be higher. The high rate of interest would see more people being refused finance. In addition, those who could afford finance would have to put a more significant element of their household income towards interest payments. These two scenarios would reduce consumer spending, reduce demand for goods and services and reduce pricing pressure.

You also have to consider those who already have debt and what interest rate increases mean to them. When interest rates increase, lenders tend to apply the rate hikes as quickly as possible to borrowers with variable-rate loans and mortgages. This means households lose some of their purchasing power because of the speedy implementation of the new bank rate, which makes their variable-rate loan or mortgage debt more expensive. In addition, borrowing money becomes far more difficult, and many find themselves being turned down by commercial banks when interest rates are high due to affordability factors. So, it can become more challenging to switch to better deals to reduce costs.

As a result of having less disposable income, these consumers have less money to spend on non-essential purchases. Again, this impacts demand for services and products, affecting inflation rates.

Related article:   PM warns central bank on rate hikes

When it comes to consumer spending, a lot has gone on over recent years. The Covid-19 pandemic meant that people could not go out and spend as they did previously, leading to a drop in spending but a surge in savings levels.

More recently, Russia’s invasion of Ukraine has affected the cost of living via rocketing energy bills. Higher inflation measured via the Consumer Price Index has led to crippling living costs and has seen interest rates rise. The cost of food has also gone up significantly, further impacting disposable income levels for average consumers.

CPI inflation and the resulting interest rate hikes have had a severe financial impact on those on variable mortgage rates. Even those on fixed-rate mortgages will be affected by rate increases at some point when their fixed-rate deal ends. Some took out their fixed-rate mortgages when rates were very low, so moving onto the variable rate or even another fixed rate in the current high-interest environment will come as a shock.

The reduced purchasing power and consumer spending resulting from this could bring down CPI inflation, leading to lower interest rates. However, with the inflation target sitting at just 2%, there is still a long way to go in terms of deflation.

Funds on deposit

When interest rates are relatively low, consumers and businesses with funds on deposit will earn relatively little interest. Consequently, those with savings may look to invest, spend on themselves, or improve their home. This additional spending will increase demand for goods and services, creating inflationary pressure. At the same time, businesses may invest in expansion, creating new jobs, enhancing consumer spending, and creating more demand.

In high-interest rate scenarios, savings will attract relatively high-interest payments, which are deemed “risk-free“. This reduces the attraction of investing and spending, deflating any inflationary pressure. High-interest rates may also see businesses pull back from expansion, possibly decreasing their workforce and resulting in a fall in consumer spending. The higher the savings rates, the less upward pressure on inflation and vice versa.

Related article:   Bank of England forecasts: Helpful or misleading?

Of course, it is worth noting that many lenders take their time to apply increases for savers following any rate hike announcement from the MPC. This means that savings accounts are left at lower rates in the short term even when the base rate increases. So, those with savings accounts continue to spend rather than save, at least for a while, because the rate of interest they are earning is still low.

Controlling the consumer spending tap

Over the years, you will notice that the Bank of England has used base rates as a primary tool to control inflation, along with tools such as quantitative easing. Increasing the cost of finance will reduce expenditure, reducing demand and inflationary pressure. Lowering the cost of borrowing will encourage consumers to take out credit cards and loans, increasing consumer spending. This, in turn, will create additional demand for goods and services, pushing prices higher.

The inverse relationship between interest rates and inflation

Whatever angle we look at, there is an inverse relationship between interest rates and inflation. Consequently, base rates have proven to be a handy tool to reflate lacklustre economies and deflate overheating economies.

Over 2022 and into 2023, we have seen how rising inflation has impacted interest rates and affected the financial market. Bank of England senior officials have said that rate hikes are necessary to continue bringing inflation down. So, as long as inflation levels remain high, there is an ongoing risk of further rate hikes.

So, the link between inflation and interest rates is powerful and can work both ways. Low interest rates can result in higher inflation. Higher inflation leads to increases in the base interest rate. And increases in the base rate can result in lower inflation.