Inflation & interest rates explained

Throughout the last 2 years, inflation has been a key concern for everyone around the world, increasing from the target of 2% in July 2021, peaking at above 10% in 2023. As of June 2024, it had returned to its target of 2%.

Taking steps to understand how inflation and interest rates in the UK impact each other is a good way of improving your financial wellbeing. On this page, we look at what inflation and interest are, how they work together and how they may affect you.

Inflation is the rate at which prices are rising, and therefore also the rate at which the value of money is falling. For example, if the cost of a £12 cinema ticket rises by 50p, then cinema ticket inflation is 6%.

As well as goods like food and fuel, inflation applies to services too, like having your windows cleaned or getting a haircut. Inflation targets are set low enough so that the average consumer won’t notice an increase from year to year. However, in the long term, these price rises will have an effect on how valuable your money is and what you can buy with it. This is also known as ‘purchasing power’.

The annual inflation rate for the UK is set once a year by the Bank of England, which is the central bank in the UK. Inflation is calculated by comparing the price of a set list of goods and services against the previous year’s prices. This list of goods and services is called the ‘basket of goods’.

The ‘basket of goods’ is a list of around 180,000 products and services that the average consumer purchases. The prices of these products and services are put into the consumer prices index (CPI), the most common measure of inflation.

Inflation is reviewed every year because consumer spending habits change, and different things become popular or in demand. This table shows the difference between the basket of goods in the 1940s vs 2018:

Most of us are affected by increased prices, but if you earn a low wage or don’t have an emergency fund saved, you’re likely to feel the increases more acutely.

For example, if your salary is rising by less than inflation, the purchasing power of your wages will decrease because what you’re earning won’t get you as far as it used to.

Some people’s income will increase in line with inflation, so while they might notice that things are getting more expensive, they shouldn’t be worse off.

Thanks to the relationship between inflation and interest rates, inflation can also have an effect on your savings and any pension pot you have, which we explore below.

In theory, inflation and interest rates directly affect each other. History shows us that when interest rates are low, inflation tends to rise – and conversely, when interest rates are high, inflation falls.

When the cost of living increases sharply, the Bank of England might consider increasing interest rates. When interest rates increase, the cost of borrowing rises, and this means that borrowers have less cash to spend. It also means that if you do have cash, you might be more likely to lock it away in return for high interest payments on accounts like fixed rate bonds.

Essentially, as demand for goods and services fall due to higher interest rates, prices should follow and therefore the inflation rate reduces. This is, however, a tricky balancing act to achieve, especially in an unpredictable economy.

If you have savings locked away, many economic experts argue that unless the nominal interest rate is beating the rate of inflation, your cash will (in theory) be declining in value. This is known as the Fisher Effect, an economic theory created by economist Irving Fisher. To work out whether your money is losing purchasing power, he developed this formula:

For example, let’s say Alison has found her dream car. The car costs £14,000, and she already has a lump sum of £14,000 to pay for it.

However, Alison wants to take advantage of current interest rates on savings accounts and plans to grow her £14,000 so that next year, she will be able to afford the car and something else after her added interest.

Alison locks her £14,000 in a one year fixed term savings account paying 5% interest. At the end of her term, Alison has £14,700.

However, during this time, the inflation rate was 6%, meaning that the car now costs £14,840. So, because of the difference between the inflation rate and the interest rate over the span of a year, Alison’s savings have lost purchasing power.

If the rate of inflation increases quickly and unexpectedly, the Bank of England can try to tackle it by raising interest rates.

This means that if you have borrowed money on a variable interest rate, you could see your monthly payments increase.

The basic principle is that when borrowing costs more, we’ll have less money to spend. That means we won’t buy as much and prices will decrease as a result.

However, if inflation is caused by something external or even global, like the cost of oil or a shortage of lorry drivers, raising interest rates might not be the solution.

Raisin UK gives you access to a range of competitive savings accounts from our UK partner banks. Simply register for a Raisin UK Account to apply for free today.