Simple Pound

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Everyone who is even just remotely interested in financial markets or personal finance is eagerly waiting to see whether the Bank of England will decide an increase in interest rates today.

We currently have a base rate of 5.25% which means that the Bank of England (BoE) charges 5.25% interest for loans that high-street banks take out in order to lend money to their customers. That means when the BoE decides to increase interest rates, any retail bank that seeks to borrow money will have to pay more interest on it. Since banks don’t usually like to decrease their profit margins, an increase in the base rate will almost certainly be passed on to consumers.

Now, how does that help with inflation? Inflation is the result of more money being spent than output produced - prices increase in order to bring down demand. As a matter of fact (and especially with the growing debt level in the UK) the money people spend isn’t necessarily money they have earned (i.e. a salary) but frequently money they have previously borrowed from a financial institution. Think houses, cars but also any balances carried forward on credit cards…

If the BoE now increases interest rates, borrowing money gets more expensive as high street banks adjust their offers. While you might be able to borrow £10,000 with 5% interest in a time where the base rate is 4%, you will certainly have to pay at least 7% when the base rate approaches 5.5%-6%. Assuming a loan period of 3 years, this results in a difference of roughly &pound20 a month. While £20 doesn’t sound too much, you still end up paying £300 in interest more a year. Therefore, with an increase in the base rate, it gets more expensive for people to take out loans or a mortgage. This in turn should make people think harder about whether they really need to take out this loan, and hence reduce demand and thus spending.

On the other hand an increased base rate means that people are likely to get more interest on their savings (because banks get more money for theirs at the Bank of England…). If you can suddenly earn 7% a year in interest when before only a meagre 4% were available, you are more likely to leave your money in the bank, rather than go out and buy some more shoes . It’s easy to see that more money in savings means less money being spent…

The overall effect of an increase in interest rates is therefore a reduction in demand and associated spending. This in turn reduces inflation as now production can keep up with demand and we (theoretically) return to the equilibrium price for our goods. If you’re keen to find out more about how monetary policy works, the Bank of England website is a very good place to start reading…

Back to real life - the interest rates meeting is on today. Analysts and the City in general have been speculating for weeks what the outcome of said meeting might be. While about a week ago, the BBC published an article that proclaimed interest rates would have to be raised to at least 5.75%, predictions got a lot more modest now.

One of the strongest indicators for a potential increase in interest rates on Friday is the fact that the Bank of England failed to hold its 2% (CPI) inflation target. Inflation was at 3.1% in March and in order to bring this back down, raising interest rates seems like a sensible option. And while you could panic because an increase would bring the interest rate to its highest value since 2001, putting it into perspective shows that it has been, in fact, hovering around a historically low value - especially if you compare it to figures for the early 90s.

However, there are some voices in the market who suggest that a raise in interest rates might not at all be necessary. First of all, the effect of the high energy prices that contributed to the rise in inflation is coming to an end as utility companies (are being forced to) pass on their cost savings, which will reduce people’s utility bills. Further, the growth in house prices is finally slowing down (yes! ) and the number of approved mortgages is even decreasing! All these signs could mean that we’ll be back on track with 2% inflation by the end of the year.

Let me know whether you think an increase is likely, and why (or why not). We can later check who got it right and even though the first person who guessed correctly won’t be getting a freebie, you can still prance around knowing you’ve got it all figured out.

Update: The Bank of England announced an interest rate increase of 0.25% to 5.5%.

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