How changing interest rates affects inflation

Prices are rising and the Bank of England is under pressure to raise interest rates to support the economy – but how does changing the interest rate affect what a family has to pay for food, fuel and mortgages?

Inflation is the result of the amount of money spent in the economy increasing at a faster rate than a country makes money from goods and services.

Changing interest rates is a tool for economists to tackle inflation.

The government’s inflation target is a rate of 2%, which is considered a reasonable figure for an n economy with stable prices. The current rate is 3.7% – almost double the target and less than the predicted rate of about 4.5% that inflation is expected to reach around April or May.

Prices are going up because the costs of raw materials are rising for various reasons around the world – like demand from growing economies in China and the Far East, floods, and a major oil pipeline fracture in Alaska.

Rates will rise – the question is when?

The recent rise in VAT will also raise inflation when it works through the figures in coming months.

Lowering interest rates makes savings less attractive and borrowing more attractive – the money paid as interest on loans is low but the cost of borrowing is cheap. Low interest rates stimulate spending because families pay less for borrowing and have more excess money to put back in to the economy.

Typically, this extra money is spent on reducing debt or goods and services because the returns on investment are low.

Raising interest rates encourages savings and discourages spending because the amount of excess money in the economy is reduced.

The pressure on the Bank of England to raise interest rates is to hike the cost of borrowing to combat inflation.

Interest rates will inevitably rise, the question is when.

Although the Bank of England is under stress to act now, the smart money from economists and analysts is no change in rates until at least October.