This page was last updated on 2 November 2023
What links the cost of living and inflation?
The prices you pay at the supermarket check-out, the petrol pump, and many other places have risen quickly in recent years.
Inflation is the measure of those increases.
When prices are rising too quickly, the rate of inflation is high. It means you can buy less with your money than you did before. So your cost of living is higher.
The UK government sets us a target of having low and stable inflation. As the UK’s central bank, the best tool we have to slow down rising prices is interest rates.
The Consumer Price Index (CPI) is the measure of inflation often talked about in the news. It tracks how the prices of about 700 things are changing. That basket includes food, household bills and transport.
Here is an example. Say the total price tag of that basket is £100. And exactly one year later, it’s £107. That would mean inflation was 7%. Rounded up, that is about what it is now (6.7%).
Inflation was 11% around the end of 2022. So overall price rises have started to slow down since then.
But not all prices move at the same rate. Right now, food prices are going up faster than overall inflation. But the price of some things (eg butter) has dropped.
How do higher interest rates help to slow inflation?
Interest rates on mortgages, loans and savings are at their highest level for many years.
The reason for that is we are using interest rates to slow price rises in the UK. We have put up the UK base interest rate 14 times over the past two years.
The Bank of England sets the UK’s base interest rate, Bank Rate. It’s also sometimes known simply as ‘the interest rate’. Bank Rate influences the level of all other interest rates in the UK.
Bank Rate was almost zero (0.1%) in Dec 2021. It is 5.25% now.
In the years between 1970 and 2009, Bank Rate was 3.5% at its lowest point and 16% at its highest. We cut it to 1% in 2009 to support the UK economy during the global financial crisis. We kept it low after that to support the UK economy.
Higher interest rates increase the return on savings. They also make the cost of borrowing more expensive.
Higher interest rates help to slow down price rises (inflation). That’s because they reduce how much is spent across the UK.
Experience tells us that when overall spending is lower, prices stop rising so quickly and inflation slows down. That has started to happen in the UK. We need to make sure it continues to happen.
People have told us directly that they are finding higher mortgage and loan payments very hard. They also ask if higher interest rates are the best option we have.
The answer is yes. The UK government sets us a target of getting inflation to 2%. And interest rates are the best tool we have to slow down price rises. We know that interest rates are an effective tool for managing inflation, because they have been used successfully across many countries and circumstances. They are effective in influencing the amount of spending in the economy, and therefore inflation. And we can see that they are working now.
Why is my loan or saving interest rate different?
When we change our interest rate, banks will usually change the interest rates for both savers and borrowers.
But, to cover their costs, banks normally pay less to savers than they charge to borrowers. So there’s usually a gap between rates on savings and loans.
What do you consider when you set interest rates?
Before we make a decision, we have to understand the state of the economy now and what it’s likely to be in the coming months. The things we look at include:
- how fast prices are rising
- how the UK economy is growing
- how many people are in work
Before each decision, we use this evidence to judge whether interest rates need to increase, stay the same, or fall. At the moment inflation is falling, but there’s still a long way to go. We need to see inflation fall all the way back to our 2% target. And so we will keep interest rates high enough for long enough to make sure that happens.
Who makes the decision on interest rates?
A group of nine people are responsible for setting the UK’s base rate. They meet to look at the evidence and make a decision about every six weeks.
They are our Monetary Policy Committee. Every three months, they give detailed reasons behind their decisions in a Monetary Policy Report.
The MPC will announce its next decision on interest rates on Thursday 14 December 2023.
Why didn’t the Bank of England act sooner?
We started raising interest rates in December 2021. The economy was just emerging from the pandemic. Our main concern around that time was whether the ending of the Covid furlough scheme would mean a lot of unemployment and so weak spending in the economy and low inflation.
Once we saw that the end of furlough wasn’t generating widespread job losses, we started to put up interest rates. If we had raised rates much earlier than that, we would have been doing it in the middle of the pandemic. At a time when our economy was very weak, and the future of millions of people’s jobs was uncertain. We knew it would have been a bad idea.
Even in December 2021, no one was expecting a war in Ukraine and what was about to happen to gas prices as a result. Our job is to react to unexpected events and make sure that inflation comes back to the 2% target. We can’t pretend that we can predict these events.
Why is inflation so high?
Three large economic shocks caused high inflation in the UK.
The first was the Covid pandemic. To start with, it led to a big shortage of products and services. That was followed by a sudden huge demand for them. That was the first thing that started to push up prices.
We knew the effects of the pandemic would not last for long. But they were followed by a second big shock. That was Russia’s invasion of Ukraine. It had a huge impact on energy and food prices.
Then, the third shock was a shortage in the number of people available for work in the UK. Thousands of people dropped out of the workforce following the pandemic. That pushed up the cost of hiring people. Employing people is a large part of costs for many businesses. So some of them put up their prices to cover those costs.
There are two main causes of inflation.
One is sometimes called ‘cost-push’ inflation. This can occur when there is a fall in supply of a product or service, which causes its price to rise. For example, after Russia’s invasion of Ukraine, the supply of gas from Russia fell significantly. This in turn meant that price of gas – which is a key source of energy in the UK – rose significantly. That pushed up on inflation both because households consume energy directly (in the form of domestic gas and electricity supplies) and also because higher energy costs make it more expensive for businesses to produce many other goods and services.
The other is referred to as ‘demand-pull’ inflation. This is when there is an increase in the demand for something relative to its supply. For example, if there is too much money in the economy, that can lead to more demand for goods and services than there are available, which pushes up on prices and inflation.
Recent high inflation in the UK has been driven mainly by ‘cost-push’ inflation. That happened first after the supply shortages due to the Covid pandemic and the invasion of Ukraine. And more recently, fewer people available to work after the pandemic is also ‘cost-push’ inflation. It pushes up on wages and businesses costs and prices.
Why is the inflation target 2%?
The government has set us a 2% inflation target.
That is the target many other countries have. It is low enough to keep prices rises small. But high enough to avoid the problem of deflation (when overall prices fall).
Inflation in the UK was 2%, on average, between 1997 and 2021. This is the level we want to get back to.