Generally, when people feel like spending – in other words when demand for goods and services exceeds supply – inflation tends to rise. When people don’t feel like spending and supply exceeds demand, inflation tends to fall.
So to meet the inflation target, our Monetary Policy Committee (MPC) changes the official Bank of England interest rate (also known as Bank Rate or the Base Rate). This is the rate of interest that we pay on reserves held by commercial banks at the Bank of England. Generally, banks pass these changes on to customers. So if we raise Bank Rate, these customers tend to receive more interest on savings and/or pay more interest on debt like loans and credit cards, and vice versa.
So, if inflation looks set to go above target we would probably increase interest rates so people spend less, which tends to reduce inflation. Or if inflation looks likely to fall below target we would probably cut interest rates to boost spending in the economy and help inflation to rise.
If we miss the inflation target by more than 1 percentage point either side – in other words, if the CPI inflation rate is more than 3% or less than 1% – the Governor of the Bank of England must write a letter to the Chancellor. This letter explains why inflation has increased or fallen and what the Bank of England proposes to make sure it comes back to target.