What are interest rates?

When interest rates are mentioned in the news or by policymakers and economists, they are usually referring to the ‘Bank Rate’ (also called Bank of England base rate).

The Bank Rate is the key interest rate in the UK because it influences many other interest rates in the economy. That includes: mortgage lending, savings rates and the amount charged on credit cards and bank loans.

The Bank of England’s Monetary Policy Committee (MPC) sets the Bank Rate as part of action to keep inflation at its 2% target over the medium term (see Chart 1). The theory is that if you make borrowing more costly, people will have less money to spend, which reduces consumer demand and eventually lowers inflation.

While the government sets the 2% inflation target, the Bank of England acts independently of the government in deciding how to achieve this goal, including how it sets interest rates. The MPC sets interest rates eight times a year.

How do interest rates affect people and businesses?

There are winners and losers from changes in interest rates. If rates rise, the losers are typically people with mortgages and debt who will face higher costs, particularly if they are on a variable rate.

Businesses also borrow less, making them less likely to create jobs and invest.

The winners are people with savings who should get a bigger return on their deposits. In contrast, when interest rates fall, borrowers’ benefit, while savers lose out.

What is the state of play in June 2024?

Since December 2021, interest rates have risen sharply from 0.1% to its current rate of 5.25% - a 16 year high - as the Bank of England tried to tackle the biggest inflation shock in over 40 years. However, interest rates have remained on hold at 5.25% since August 2023. 

What is the outlook for UK interest rates?

With UK inflation close to the Bank's 2% target, a couple of interest rate cuts this year are possible. However, lingering concerns over underlying inflationary pressures may delay the timing of any loosening of policy and when rates do start falling, the reductions will be gradual.

If more rate setters vote to ease policy at upcoming meetings, this would be a sign that rate cuts are on the horizon.

Some of the main challenges facing UK interest rates

• A time-lag of around 18-24 months (estimated by the Bank of England) between raising interest rates and the full impact on the wider economy means they are a rather blunt instrument to tackle inflation.
• Increasing borrowing costs risks harming the economy. For example, an estimated 1.6 million homeowners will see their mortgage deal expire this year and face a notable rise in their mortgage costs.
• Challenges of a weaker currency, including imported inflation, if the UK cuts interest rates ahead of the US.