How Do Interest Rates Affect Us and the Economy?

Published / Last Updated on 05/03/2024

11 years ago, we shot a video on how interest rates affected us and the economy.  At the time Bank of England interest rates were at just 0.5% pa with mortgages available at below 2%, 3% and 4% pa.  A generation has grown up since the credit crunch crisis of 2007 only knowing low interest rates and even lower during the pandemic with base rates at just 0.1% pa.

More recently, we have all experienced higher costs of living compounded by the Russian invasion of Ukraine, the energy crisis and now the costs of living crisis driving the costs of living even higher.  To combat double digit inflation the Federal Reserve, the European Central Bank, the Bank of England, and most central banks increased base rates.  In the UK, the Bank of England base rate is currently 5.25% pa meaning many mortgage rates have doubled over the last couple of years.

Impact on Individuals

It’s perhaps more obvious for many now to understand the impact interest rates can have on our lives personally.

  • Higher interest rates mean higher mortgage and debt repayments meaning we have less money to spend (to bring down inflation).
  • Higher interest rates mean better savings returns on our cash investments meaning we spend less and save more (to bring down inflation).
  • Higher interest rates mean higher gilt/bond yields, so the capital value of your fixed rate or index linked fund will fall but pension annuity rates are higher i.e., you can get a bigger annuity income at retirement.
  • And vice versa when governments need to stimulate the economy and reduce interest rates.

Impact on the Economy

Most governments need to borrow money to fund public services as well as benefits and infrastructure projects.  The interest rate that government’s pay on their debt borrowing (Treasury stocks, gilts and bonds) is indirectly linked to interest rates.

If you could earn 4% by depositing your money in a bank and the government was only prepared to pay a 3% gilt/bond yield (interest in plain English) on its debt, why would you ‘lend’ your money to the government?  You may as well ‘lend’ it to a bank (deposit) where you earn 4% and they then lend it out via a mortgage at 5% or 6% pa.

  • Higher interest rates mean gilt/bond yields need to be higher, so it costs the government more to borrow money. 
  • This means governments will make spending cuts or will increase taxes and debt interest payments are higher.
  • Higher interest rates also mean the capital value of existing gilt or bond funds (that you may have in your pensions or investments via Fixed rate and Index Linked bond funds) will fall in value as the fund may have gilts/bonds paying a lower rate when interest rates were lower.
  • Higher gilt/bond yields also mean pension annuities are cheaper for defined benefit pension schemes from big companies and local/central government schemes meaning companies as well as central/local government are not under as much pressure funding their big pension schemes.
  • And vice versa.

Interest rates therefore have a huge impact on the economy both at a ‘micro’ personal level but also at a ‘macro’ government level.

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