The headlines have been filled with news of sky-high inflation and the Bank of England’s subsequent interest rate rises. But we thought it would be handy to go through exactly why inflation is high, how interest rates are meant to curb it and whether it’s actually working.

Why is inflation high?

In an ideal world inflation would hover around 2%, but in August 2021 it started rising sharply before hitting a peak of 11.1% in October 2022. Inflation is the rate at which prices are rising, based on an example basket of goods that the Office for National Statistics puts together. This virtual basket has a variety of items, from haircuts to flights abroad to a pint of milk.

Inflation rose after the pandemic, with much of it linked to the Covid-19 crisis. As countries around the world emerged from various lockdowns, the demand for goods and services rose. The higher the demand for an item, the higher prices will go. At the same time, a lot of supply wasn’t there, creating scarcity, which pushes up prices further. Let’s take the car market as one example, there was shortage of chips for new cars, which meant fewer were available. That pushed up prices of both new and second-hand cars, which feeds into inflation figures.

Brexit also impacted the UK – although it’s trickier to measure the exact impact of this and separate it from the post-pandemic demand boom. But there is some data that shows it caused a worker shortage, further impacting that supply/demand issue.

This was meant to be a short-term blip while companies and factories got back to full speed post-pandemic. But then the Russia-Ukraine war broke out, which impacted several markets from wheat to oil to energy – creating another supply problem and pushing up prices again.

The fallout from a period of high inflation is that workers demand higher wages to help them keep pace with rising costs, but that in turn pushes up costs for businesses who then raise prices to pay for them – leading to more inflation.

Why will interest rates reduce inflation?

The Bank of England is limited in what it can do to curb inflation – and its main tool is interest rates. The Bank wants people to stop spending so much money, so there is less demand for items and prices can stop rising by so much (or even fall).

If it hikes interest rates that pushes up the cost of borrowing, from credit cards to debt, which discourages people from borrowing money that they will then spend. For example, when borrowing is cheap you might buy a new sofa and put it on your credit card, but if that’s going to cost you a lot of money in interest you might decide to delay the purchase. At the same time, a higher base rate pushes up the interest rates on offer to savers, meaning they might be more inclined to save money in their bank account rather than splurge it on a new holiday or a new car.

The unfortunate side effect of this is that it will slow the economy – if fewer people are buying things that reduces growth in the economy, which can have the knock-on effect that businesses must cut costs and lay-off staff. In turn that means less chunky pay rises for staff, as there are more unemployed people willing to work, meaning businesses have their pick of staff and so don’t have to pay them more.

That’s all the theory, but there are lots of variables that impact how this works in practice – as we’ve seen in the current economy and previously. If the Bank pushes rates too far it risks the economy falling into recession, but not far enough and it risks failing to curb inflation, which will then keep climbing.

What impact have rate rises had on our personal finances

Both savings and mortgage rates have shot up – but the impact hasn’t been as direct as some might have assumed. Let’s take savings rates first, the top easy-access account has risen from 0.65% in August 2021 up to 4.8% today, according to Moneyfacts. The fixed rate market has seen a bigger increase, with a one-year fix going from 1.31% two years ago to 6.02% today.

But banks haven’t increased rates by as much as the Bank of England hoped. While top rates have risen a lot, the average savings account hasn’t seen anywhere near that increase. On top of that, there is £270 billion of savers’ money sitting in accounts earning no interest at all. At the same time inflation is still higher than cash savings rates, meaning that even if you’re earning the best rate out there your money is losing spending power in real terms, which is a detractor from saving.  It means that the draw to save money rather than spend it isn’t as alluring as it might be.

On the other side mortgage rates have gone up sharply: the average two-year fix has gone from 2.52% in August 2021 up to 6.85% today, according to Moneyfacts. That will have a dramatic impact on people’s mortgage repayments, but there is a considerable lag on the impact of this.

Most homeowners are on fixed-rate mortgages, which mean rising mortgage rates make zero difference to their finances until they come to re-mortgage. That means that there is a slow, rolling impact of rising rates, rather than a quick, sharp one. The Bank of England estimates that only around half of people with a mortgage have re-mortgaged since rates started to rise in December 2021 – and some of those won’t have seen a huge increase in rates if the base rate hadn’t risen considerably by their re-mortgage date.

Are there signs rate rises are working?

Inflation has fallen from the end of last year to under 7% today, so at a base level inflation is falling. It’s still a country mile from the Bank’s 2% target, but it’s heading in the right direction. That said, so-called ‘core inflation’, which strips out a lot of the volatile prices, such as food, energy, alcohol, and tobacco, didn’t drop between June and July.

On top of that, people are still spending heavily on things like holidays, eating out, hotels and other socialising. If you’ve paid off your mortgage then you’re benefitting from higher savings rates and not impacted by the higher borrowing costs. On top of that, many people are still sitting on big piles of cash savings from the pandemic, so they are more insulated from the cost-of-living price increases.

It’s these people that the Government and Bank of England wants to stop spending, so that inflation will fall. But it’s not easy to do that without punishing those who are already hurting because of rate rises and high inflation.

In its latest report the Bank itself acknowledged that more interest rate rises won’t have a huge impact on inflation. Its own projections show that inflation will fall to 1.5% in three years’ time if it raises rates to 6% and then trims them back to 4.5%. But it also forecasts that inflation will fall to 1.4% if interest rates just stay at the current 5.25%.

It also admitted that the impact of interest rate rises is waning. But that doesn’t mean they are done with hiking. Instead, the Bank said it will ‘monitor closely’ any signs that inflation has become persistent and also the path of wage growth and will act if ‘there were to be evidence of more persistent pressures’.

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