Why Is the Bank of England Raising Interest Rates?

 Jason Mountford
Jason Mountford
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August 3, 2022
· 4 min read
Why Is the Bank of England Raising Interest Rates?
Why Is the Bank of England Raising Interest Rates?

The Bank of England is raising interest rates to combat inflation. Inflation has hit a 40-year high of 9.4%, and it doesn’t show any signs of slowing down. Having a bit of inflation is a normal part of any economy, but when it gets too high, it causes problems for everyone.

Rising prices put pressure on household budgets, with the cost of everything from energy to groceries to petrol to cinema tickets going up, often at a greater rate than wages.

It’s not just consumers who are negatively impacted by high inflation. Companies themselves feel it too. As the cost of materials increases, companies can only pass on so much in the way of price hikes to their customers. They’ll often have to dig into their own profit margins as well, which can threaten the viability of their business.

With all this in mind, it’s no surprise that the regulators want to keep inflation in check. The main organisation tasked with this job in the UK is the Bank of England.

What Does the Bank of England Do? 

The Bank of England is the UK’s central bank. The role of a central bank is to issue the currency, regulate the banks and the financial system and set base interest rates. It also serves as the official bank of the UK government, managing its foreign currency reserves and securing the country’s gold bullion.

The Bank of England is known as the ‘banker’s bank’ because, in addition to the functions above, it also operates as the lender of last resort to certain financial institutions, meaning it will lend money to other banks in times of short-term cash flow problems.

Essentially, the central bank is the cornerstone of the UK’s financial and banking system.

One of its most important roles is to manage the rate of inflation, with a target level of 2 - 3%. It aims to do this by raising and cutting interest rates.

The Impact of Interest Rates

The Bank of England’s base interest rate is really important because all other interest rates in the economy are based on it. This means that for any debt that you have, the interest rate on that debt is partly because of the Bank of England’s policy.

This is the same whether we’re talking about a credit card, personal loan, overdraft or a mortgage.

When the Bank of England raises interest rates, the interest you pay on variable rate loans (like a mortgage) also increases. Some interest rates can be fixed and won’t change when interest rates go up or down, but any new loans will be based on the new Bank of England rate.

This means the borrower will have less money to spend on other things because they have to spend more on their mortgage or other new loans.

How Do Interest Rates Impact Inflation?

When prices are going up, it’s usually because the economy is booming and people have more money to spend. With more money floating around, businesses have a high demand for their products and services and, therefore, can afford to charge more.

They’re then making greater profits, which further boosts the economy, but it can spiral out of control if prices rise too quickly. We’re seeing the impact of that now with rapidly increasing prices for everything.

Raising interest rates reduces the amount of spare money people have to spend. This lowers the demand for goods and services, forcing businesses to slow down and reduce profit margins in order to keep sales ticking over. It takes the heat out of the economy.

The opposite is true too. 

If the economy is stagnating or slowing down, the Bank of England can cut interest rates to try and stimulate it. If consumers’ mortgage repayments go down, this means they then have more money each month to spend. This can go towards purchasing goods and services which they couldn’t previously afford, which increases company sales and profits and starts a positive feedback loop into a growing economy. 

The Bank of England's Current Plan

Right now, the Bank of England is increasing interest rates to try and bring down record-high inflation. It has already hiked rates significantly over the last couple of months, and there are expected to be plenty more to come.

So far, this hasn’t made a dent on inflation, with the CPI figure in the UK continuing to rise. The Bank of England also has to balance the fact that household finances are stretched already and that increasing the cost of borrowing is going to make that more difficult in the short term.

Read: Why Inflation Risk Is the Biggest Threat to Your Wealth

Also Read: Investing For Beginners

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Jason Mountford
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Jason Mountford

Jason is a qualified Financial Adviser in both the UK and Australia and holds a Master’s Degree in Applied Finance. He loves to write about investing and personal finance, and in his spare time, you’ll find him training for marathons and spending time with his family.
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