As inflation continues to rampage across the globe, central banks are reacting by implementing frequent and significant base interest rate hikes.
In the US, for example, the Federal Reserve recently raised the base rate to 1%, its biggest increase in more than two years. In Australia, the central bank processed its first rate rise in over a decade (to 0.35%), while Mexico hiked its own interest base rate by a whopping 6.5%.
At the latest monetary policy meeting of the Bank of England (BoE), it was announced that the base rate in the UK was to increase from 0.75% to 1%. But why has this decision been taken, and what does it mean for households nationwide?
The Rising Base Interest Rate in the UK
Interestingly, the latest BoE rate increase was the fourth in six months, dating back to December 2021 (at which point the rate was as low as 0.1%).
Incredibly, a base interest rate of 1% is the highest level recorded in the UK for 13 years, dating back to the depths of the great recession in 2009. The record low base rate of 0.1% had been initially set during the coronavirus pandemic, as part of wider quantitative easing and economic stimulus measures.
But why has the BoE (and other central banks) taken such drastic measures to raise the base rate?
Well, this has much to do with rampant inflation, which recently peaked at 9% in the UK during April (its highest rate since 1982). In February, inflation had peaked at a 30-year high of 6.2% on these shores, while its continued and exponential growth means that it could rise above 10% for the first time in 40 years by the end of 2022.
With inflation driving significant increases in the cost of fuel, energy and food (this issue is also being compounded by ongoing supply issues, the soaring cost of raw commodities and Russia’s invasion of Ukraine), the UK and other nations find themselves gripped by a cost of living crisis.
Of course, a little inflation is considered desirable by economists, as it helps to boost consumer demand and consumption in a stable manner.
This is why both the BoE and the Federal Reserve have a longstanding inflation target of 2%, but the current levels of price growth are prohibitive and only serve to stifle consumer spending and demand on a large scale.
A tried and tested way of combating inflation (in the long-term at least) is to raise interest rates. On a fundamental level, this is because interest rates and inflation share an inverse relationship, with the value of one increasing as the other falls.
More practically, hiking the base interest rate instantly increases the cost of borrowing for businesses and households alike. As a result, such entities are encouraged from borrowing and spending money while saving more, potentially dragging inflation back towards a more manageable level.
This process can take time, however, and even in the likely event of the base interest rate reaching at least 1.25% this year, inflation is still likely to reach double digits at some point in the second half of 2022.
How Do Rising Interest Rates Affect You?
Ultimately, this represents a tough balancing act for the central bank, who don’t want to slow down the economy too much but can struggle to cap inflation without relatively drastic action.
But how do rising interest rates affect you? Here’s a brief breakdown for homeowners, investors and businesses:
1. Mortgages for Homeowners
Let’s start with homeowners or first-time property buyers, who will either have a mortgage or want to apply for one.
Currently, around one-third of UK adults have a mortgage, with 25% of this number owning an adjustable rate agreement that will see their monthly repayments continue to rise as the base rate soars.
Customers on a typical tracker mortgage will have to pay around £25 more each month on average, for example, while those bound by standard variable rate agreements will see an approximate increase of £16.
Compared with November 2021, when the base rate was capped at 0.1%, trackers and variable mortgage holders will have to pay £90 a month and £57 a month more respectively, creating a significant increase at a time when energy prices are also soaring.
2. Borrowing for Businesses
Even the cost of unsecured loans and credit cards could rise in line with the interest base rate, with this likely to affect households and businesses.
Prior to the most recent rise, the average annual interest rate was 20.3% on bank overdrafts and 18.01% on credit cards. Lenders will almost certainly adjust these rates to reflect the new base rate of 1%, making it more expensive for businesses in particular to manage their accounts and borrow capital.
This could lead to stagnant growth in the private sector, as firms delay their respective expansion plans and instead look to consolidate in a challenging climate.
3. Reduce Share Values for Investors
There’s also an intrinsic link between interest rates and the stock market, with sustained rate hikes likely to translate into reduced share valuations over time.
But why is this the case? Well, businesses see the basic costs of operating and borrowing rise as rates are hiked, usually leading to reduced investment in future growth.
There’s also less incentive for customers to borrow in the form of credit cards and unsecured loans, leading to a scenario where households have less discretionary income across the board.
These factors combine to simultaneously hike operational costs and reduce earnings for companies, leading to lower profit margins, more negative investor sentiment and diminished demand.
This means gradually falling share prices, ensuring that investors who actually own stock will see the value of their holding depreciate.
On the flip side, savvy investors may be able to identify diminished stock prices that offer value in the longer-term, but this is scant consolation given how hard it is to determine when the current economic climate will brighten.