Your beginners guide to inflation – and why interest rates are rising

A couple of years ago, only economists and data nerds really pored over the UK inflation figures, as they didn’t move that much and were generally low. But now inflation is front-page news, and chat in the pub has turned to interest rates and the rising price of milk (among other, more fun, topics).

But with a lot of numbers and technical jargon being flung around, it’s easy to just nod along without really understanding why inflation is high, what the Ukraine war has to do with the price of bread, and why cripplingly high mortgage rates are needed to make it all better. So, here’s all the questions you wanted to ask about inflation and interest rates – and the answers!

What is inflation?

Inflation is measured by the Office for National Statistics (ONS), and it’s the rate at which prices are rising over the past year. For example, if inflation is 2% that means that something that cost £100 a year ago will cost £102 today.

The ONS base it on an example basket of goods to try to replicate all the things that the average household buys, so it has a variety of items, from theatre tickets to flights abroad to a pint of milk or a pair of football boots. Even if the headline rate of inflation is high, that doesn’t mean everything is rising in price, as some items might have dropped. But it means that the overall basket of goods has risen in cost.

Why has inflation risen by more than usual?

Usually, the aim is for inflation to be around 2%, but two years ago it started rising above that and even hit a peak of 11.1% in October 2022. But why? Inflation rose after the pandemic as the world emerged from restrictions and lockdowns, and suddenly there was a big demand for goods and services. Many people had also saved a lot of money during the pandemic and now they wanted to splash the cash. Generally speaking, the higher the demand for an item, the higher its price.

At the same time, there were issues with keeping up with that demand, as companies couldn’t make things fast enough – either because of delays in getting parts or because they needed to hire more staff. That created scarcity, which pushes up prices further. For example, anyone who tried to buy a new car saw that there was very little stock available, which in turn pushed up prices for both new and second-hand cars. All of these price rises feed into the inflation figure.

The UK had also just gone through Brexit. It’s quite tricky to work out the exact impact of this and separate it from the post-pandemic demand boom. But there are signs that it led to a worker shortage, hampering companies’ hiring plans.

Lots of experts dismissed this as a short-term problem while the world got up to full speed again, but then the Russia-Ukraine war began. That alone caused disruption to a number of different markets – energy was the most notable, but also wheat and oil. That created another supply problem and pushed up prices again.

There’s a second element to inflation too – once it’s been high for long enough workers want payrises that keep up with it – or at least come close to it – otherwise they are effectively getting poorer each year because they wages don’t buy as much stuff. But when businesses pay their staff more, their costs go up, which often means they have to raise prices to cover that higher cost – which once again feeds into inflation figures. It’s a bit of a vicious circle.

Why does that mean interest rates have to rise?

The Bank of England (BoE) is in charge of keeping inflation at 2% - or near it – and works independently of the Government. But that means it’s pretty limited in what it can do to lower inflation – its main tool is interest rates. Essentially, 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.

By raising interest rates, the BoE pushes up the cost of borrowing, so the interest rate you’re charged on your credit cards, personal loans or mortgages. That 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. Or, when mortgage rates are cheap, you might be happy moving to a bigger, more expensive house and taking out a bigger mortgage, but when rates are high, you’d be more inclined to delay this.

At the same time, higher interest rates push up the return that savers can get. We’ve seen the rates war in the savings market push rates up to 5% or higher. That means that savers should be more inclined to save money in their bank account rather than splurge it on a new holiday or a new car.

Are these interest rate hikes actually working?

Despite lots of interest rate rises by the Bank of England, inflation has been slower to fall than both the Bank and the Government hoped. But it has dropped from that peak of 11.1% last year to under 7% in July.

But there is lots of data out there that points in different directions. For example, on one hand, there is lots of evidence that people are still spending money on non-essential things like holidays, new sofas, eating out and trips away. But on the other hand, we’re seeing signs of a housing slowdown and drops in house prices as people are reluctant to move and take on bigger mortgages while interest rates are so high.

Higher interest rates create two groups:

• Those who have paid off their mortgage and have high savings benefit from higher interest rates and aren’t affected by the higher cost of borrowing.
• Those who have big mortgages (and potentially other debt) and little savings are hit by high rates on their borrowing but don’t benefit much from the savings rate increase.

So, the Bank needs to balance its need to stop people spending so much without causing too much pain on those with mortgages and lots of borrowing.

Are more interest rate rises coming?

The data that the Bank of England relies on to make its decisions is changing so quickly, so the expectations of what the Bank is going to do with rates change pretty regularly too. But, at the moment, it’s expected to increase them to around 5.75% or 6% and then keep them there for a while.

What’s interesting is that the Bank itself has said that more interest rate rises won’t have a huge impact on reducing inflation. Because lots of people are on fixed-rate mortgages they don’t feel any impact of higher mortgage rates until they come to re-mortgage. That means there’s a delay in the impact of higher interest rates.

But that doesn’t mean the Bank will halt its interest rate rises – it has instead said it will “monitor” the data closely.