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Interest Rates and Inflation

Expensive Food Shopping

22nd August 2023

Dexter Lawrence Written by Dexter Lawrence

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It’s hard to avoid news of increasing interest rates and high inflation these days.

Since 1997, The Bank of England has controlled Monetary Policy in the UK, specifically their Monetary Policy Committee.

The Bank of England opened for business as a private bank on 1st August 1694. With just 17 clerks and 2 gatekeepers, it was established to act as banker to the Government. The original Royal Charter granted by King William and Queen Mary stated that the bank should “promote the public good and benefit of our people”. 329 years later this sentiment still remains in the Bank of England today. Its present mission statement emphasises “promoting the good of the people of the UK by maintaining monetary and financial stability”.

The MPC (Monetary Policy Committee) have a target to control inflation through the use of interest rates. They always meet regularly, on a Thursday.

The latest interest rate hike on 3rd August pushed the base rate up by 0.25 percentage points to 5.25%. This is an attempt to control and ultimately lower UK inflation. The base rate or bank rate as it’s also known, determines the interest rate that the Bank of England pays to commercial banks that hold money with them. This in turn influences the rates that those banks then charge people to borrow money or that the banks pay on customers savings.

What’s all this Monetary Policy and Inflation malarky?

Put simply it’s the act of delicately balancing the raising and lowering of interest rates to control demand and spending. Subsequently, controlling the rate of inflation, and all whist considering economic but not inflationary growth.
Put interest rates up too high and the economy could stall or even go into a recession. Conversely, keep them too low and people have more in their pockets to spend so inflation will likely rise. Fluctuating inflation is problematic also because that makes it hard for businesses to set prices and for people to plan their spending.

What’s all this got to do with me?

If interest rates fall and you have a loan or mortgage, then the interest on these becomes cheaper. However, if you have savings, you will be paid less interest on those. Increase interest rates and borrowing becomes more expensive. This is currently evident with rent and mortgages rates. On the other hand, savers should in theory receive more interest on the money they've invested.

The idea in principal is a simple one. If people have higher borrowing costs then they will have less money to spend elsewhere. This in turn will stop prices rising at a high rate. But, if people start spending too little then this can cause businesses to fail. This can result in job losses and the economy going into recession.

What is the desired rate of Inflation?

The target rate of inflation in the UK is 2%. Two percent is 4.8 percentage points lower than the latest published figure of 6.8%.
However, this 6.8% is an average figure, and as we all know when we reach the supermarket checkout these days, some items are rising at a faster pace, for example, food.

Food inflation is currently running in the region of a whopping 17.4% according to the Office for National Statistics!

How do we measure the dreaded Inflation?

Inflation is the measure of how much the prices of goods and services have increased over time. Usually, people measure inflation by comparing the cost of items today compared to their cost 12 months ago. Calculate the average rise in prices and you’ve got your rate of inflation.

For example, if you bought something for £1 a year ago and today the same item cost you £1.07 then it’s gone up by 7%. That’s the rate of inflation.

Interestingly if inflation is too low or even negative then this is also bad for the economy and businesses. You might think that lower prices sound great, however, people might then put off spending because they expect prices to fall further. If everyone reduced their spending then companies would be likely to fail. Subsequently, there could be job losses and an economic downturn. This brings us back to the balancing act mentioned before and the optimum 2% inflation target.

If the Bank of England miss their 2% target by a percentage point on either side, then the MPC must write to the Chancellor of the Exchequer explaining why. They must also outline what they intend to do to bring the inflation rate back to 2%.

In the UK, the Consumer Price Index or CPI as it’s more commonly known, is used when measuring inflation.
Each month the Office for National Statistics (ONS) collects around 180,000 prices of over 700 items, called the 'shopping basket'. Imagine a large shopping basket full of everyday goods and services that we all buy! This shopping basket is then reviewed annually. The items in it change so that they are representative of consumer spending patterns and habits.

For example, in 2023 26 items were added to the shopping basket and 16 items were removed out of a total of 743 items.

The additions and removals make for interesting reading...

How was the 'shopping basket' changed?

Items added include e-bikes, security and surveillance cameras, frozen berries and some types of train tickets bought. Infant dresses and green beans were also added. As were video doorbells, margarine was split from dairy free spread, and to reflect purchases made as part of the growing lunchtime food trade, the price of individual apples was also added alongside the price per kilogram! Removals included digital compact cameras, spirit-based drinks, non-chart CD albums and non-film DVDs bought in a shop.

So next time you cycle to work on your e-bike, safe in the knowledge that your video doorbell will monitor visitors to your front door, munch on a single apple at lunch, and then pop into the supermarket for a packet of green beans and tub of frozen berries on your way home, know you’ll be helping to compile the UK’s rate of inflation.

Further Suggested Reading: Inflation Rates - What does this mean for businesses?