How do interest rates affect inflation? - Times Money Mentor (2024)

Inflation has soared in recent years prompting the Bank of England to raise interest rates. Here we explain how the two measures are connected, and what it means for your money.

Inflation is the measure of how much the things we buy are going up buy over a period of time. One of the jobs of the Bank of England to keep inflation low and steady, setting a target of 2%. In the autumn of 2022, CPI hit 11.1%.

One tool the central bank can use to bring the cost of living down is to raise interest rates in order to make borrowing money, such as a mortgage, more expensive.

In this article, we explain:

• How is inflation measured?
• Does higher inflation means higher interest rates?
• How does raising interest rates help inflation?
• What does higher inflation mean for your savings?
• How will inflation affect your pension?

RPI vs CPI inflation: what’s the difference?

What is the ‘bank rate’?

Interest is what you pay a lender in exchange for borrowing their money. It is also what banks pay you for saving your money with them.

The most important interest rate of all is the Bank of England base rate. It is set by the MPC’s nine members and is what underlies the rates banks pass on to their customers.

The base rate rose 14 times in a row between December 2021, when it was at a record low of 0.1%, and August 2023. Since then it was static at 5.25% for a year until August 2024 when the Bank opted to cut the base rate to 5%.

The rate affects all sorts of aspects of the UK economy including:

• How expensive mortgages and loans are
• How much savers get paid for their bank deposits

When economists at the Office for National Statistics (ONS) calculate the rate of UK inflation, they look at how the price of a basket of products have risen or fallen compared to the previous year.

In the year to July 2024, the consumer price index (CPI) measure of inflation actually rose slightly from 2% the previous month to 2.2% due to gas and electricity prices falling by less than the previous year.

The figures is calculated by looking at the prices of about 180,000 products and services then and now – with the exact products chosen based on what people typically buy.

By measuring the price change of this “basket” of goods we get a figure for the consumer price index (CPI), which is the most widely used measure of inflation.

The retail prices index (RPI) is another inflation measure used. Like the CPI, it draws on a basket of goods and services but adds mortgage interest payments.

In the year to July 2024, the RPI inflation rate was 3.6%, up from 2.9% in June. We have much more on the difference between RPI and CPI inflation and how this affects your money.

How does increasing interest rates reduce inflation?

Increasing the bank rate is like a lever for slowing down inflation. By raising it, people should, in theory, start to save more and borrow less, which will push down demand for goods and services and lead to lower prices.

Before December 2021, interest rates had been at a record low so people were encouraged to borrow money because it was cheap. On the flip side, interest rates on savings accounts were pitiful so there was little incentive to put your money aside, meaning people tended to spend instead.

But rising interest rates have increased the cost of borrowing money. In this environment, consumers and businesses are put off from spending or borrowing.

As demand for goods and services fall, this should have a knock-on effect on prices. Shops might even reduce the cost of goods to try to encourage people to buy them.

Inflation has fallen significantly since its peak at just over 11% in October 2022, an indication that the Bank of England’s interest rate hikes have been effective. But interest rates are not the only factor impacting the economy.

Higher interest rates affect millions of homeowners on variable and tracker rates. Nearly 1.4 million people are also on fixed deals that are due to expire this year. These homeowners will face significant increases when they remortgage this year.

See our guide on what the base rate means for you.

Does higher inflation mean higher interest rates?

In theory, inflation and interest rates have an “inverse” relationship:

• When rates are low, inflation tends to rise
• When rates are high, inflation tends to fall

If the cost of living is rising too quickly, the Bank of England can raise interest rates to try to slow it down. Equally, if recession strikes the Bank can rapidly cut rates to try and boost the economy – as last happened in the wake of the 2008 financial crisis.

What does inflation mean for your savings?

The Fisher Effect is an economic theory that describes how inflation relates to both real and nominal interest rates.Nominal rates describe how much a saver gets when they deposit money in a bank.

If you put £5,000 in a savings account that offers a 3.5% interest rate, you will earn £175 over a year.However, that £175 isn’t quite what it seems.

If at the same time the inflation rate is around 5%, the cash in your savings account is only losing value. After one year, your £5,000 pot adjusted for inflation would actually be worth £4,673. After five years, if inflation stayed as high, it would be worth just £3,565.

In other words, the purchasing power of your cash has been eroded, even when you add the £175 earnings. Over the long term, this really adds up.

Fortunately, top savings accounts right now pay rates that are higher than the current inflation rate. This means your savings can gain value in real time.

The key thing to remember is that there is a difference between real and nominal interest rates, and inflation has an impact on the relationship between the two.

Understanding how inflation impacts your finances is essential when creating a plan for the future. You can use this inflation calculator to work out your own rate.

How will inflation affect my pension?

Higher rates of inflation reduce the purchasing power of our cash and the value of pensions.

If, say, your pension grows by 3% this year but inflation is at 4%, your pension will actually decrease in value by 1%. You might see this written as an increase in “real terms”.

It is also worth considering “compounding inflation”. Just as with the effect of “compound interest” on savings or investments, inflation will slowly erode the rate of growth in your savings or investments.

Instead of occurring in a vacuum, where prices are reset to zero each year, inflation compounds over time. And so its impact can be significant on long-term savings like pensions.

This is why some asset managers and pension providers measure the “inflation-adjusted returns” on particular investments.

One other key element of how inflation affects pensions is the “triple lock”. Introduced in 2010, this policy means the state pension rises each year by the highest of the three factors below:

• 2.5%
• Inflation as calculated by the CPI
• Average wage growth

How to invest wisely

Another way to future-proof your investments is to do what famous investors such as Warren Buffett suggest.

Don’t just put your own money in a self-invested personal pension (SIPP) or stocks and shares ISA, but also consider engaging in pound-cost averaging.

That means picking a figure you can commit to investing, say £150, and buying shares like clockwork every month.

Sometimes you will receive relatively more for your money, and sometimes relatively less, depending on whether markets are falling or rising and on the rate of inflation.

The key point is that this approach can smooth out this volatility to build up the value of a pension pot over time.

One other potential solution in guarding against inflation is to consider IVOL. This is an exchange-traded fund (ETF) that is specifically designed to profit from increases in the expected rate of inflation.

IVOL trades on the NYSE Arca, a junior market of the New York Stock Exchange, and since it is a US-based ETF, UK investors may have to fill out a W-8 BEN form to include it in their stocks and shares ISA or SIPP.

However, as with any investing, the value of your investments can go down as well as up and you may not get back all the money you put in. All investments carry a varying degree of risk and your capital is at risk.

In conclusion, the relationship between inflation and interest rates is complex but extremely important to grasp.

Understanding how each could change in future could make a big difference to your savings and your financial comfort in retirement.

Find out the best stocks and shares ISAs.