Inflation and interest rates are something that you might know about but not sure what it actually means. Or how it affects your day to day life.
Inflation is a measure of the rate of increase in prices for goods and services. When inflation is rising you pay more for basic goods like bread, petrol, alcohol and tobacco. The cost of leisure activities such as swimming and going to see a movie will increase too.
Interest rates are the charges when you borrow money. They are also payments on the money you save. It’s basically the cost of the money you have, either as a borrower or a saver. The most important interest rate in the UK is the Bank of England Base Rate, which influences all the other interest rates.
So if you borrow money in the form of credit cards, or bank or guarantor loans, you will be charged interest for the privilege of borrowing the money. If you are saving money you will be paid interest for the bank or building society hiring your money.
If you take out a £100 loan with a 0% interest rate you would pay back just the £100. If you pay 20% interest rate it costs you £20 to borrow that £100, so you would pay back £120.
Inflation rates are often found as percentages. If inflation rises by 5% that means you are paying 5% more for the basic goods, compared to the previous year.
The Relationship Between Interest Rates and Inflation
When interest rates are low spending is likely to increase because goods cost less and people have access to ‘cheap’ money. Cheaper goods mean more people buy them more often.
When the cost of goods is cheaper the economy grows.
But as more people buy goods the costs to produce them increases and the increased cost of goods, as we’ve seen, means a higher rate of inflation.
It’s a balancing act.
The government and the Bank of England use inflation to help set interest rates. And of course interest rates affect how much you pay on your mortgage, any loans, credit cards and other borrowing.
When there is a rise in inflation, the governments may increase interest rates to try to reduce inflation (less ‘cheap’ money means the prices of goods should come down). The same applies in reverse. If there is no rise in inflation the government might cut interest rates, to create more spending power.
Inflation is measured in different ways.
The Consumer Prices Index (CPI) inflation and the Retail Prices Index (RPI) are both used to measure inflation.
But they use different formulas to calculate inflation rates.
The CPI inflation rate is usually lower than the RPI rate too. It takes into account people switching to less expensive products when prices rise.
The RPI includes housing costs such as mortgage interest payments and council tax, which the CPI does not include.
How Inflation and Interest Affects Your Money
When interest rates are low and consumers have access to borrowing money at a reduced borrowing cost, there are more people who can afford to buy. As sales of things like houses and cars increase, this increased demand drives up the price.
Then as costs rise, spending can get reduced.
Rising inflation reduces your spending power, especially if your wages don’t rise as much as inflation does.
Some businesses also use the rate of inflation as a guide to annual pay increases.
If there is a rise in inflation and you have a rate-linked state benefit, pension or savings product and you could benefit.
You can’t do much to change interest rates or inflation levels. But you can look at your spending.
If you have a fixed rate mortgage coming to an end and try to get a better deal in advance. Look at ways of reducing spending on store cards, credit cards or switching them over where you can. While consolidation loans do attract higher interest rates, it could prove a good option to put all your loans in one place.
Times are uncertain, but a few simple changes could make all the difference.