Interest rates, inflation – and managing debt

2 June 2008

If people need help managing their debts, why doesn’t the Bank of England (BoE) just slash its base rate? After all, the base rate is what helps financial companies decide how much they’ll charge borrowers and pay savers. So in general, a lower base rate means less profitable savings – but less expensive debts.

Since the credit crunch started, the USA’s Federal Reserve has dropped its rate from 5.25% to 2%, hoping to help people manage their debts (from credit card bills to mortgages) by reducing the interest they pay on them. In the UK, however, the BoE has only lowered its base rate from 5.75% to 5%. Why?

Interest rates and their impact on inflation
Borrowers and savers aren’t the only ones affected by changes to the base rate. Even someone with no debts and no savings will still feel the effects that rising and falling interest rates have on inflation (the speed at which prices grow).

When interest rates are low
Money is cheaper. Saving is less profitable – but borrowing is less expensive, so debts are easier to manage. People are more likely to borrow and less likely to save. Plus, low interest rates can boost the value of assets (like houses and shares), which also means people have more money to spend. But when spending grows too fast, this can lead to high inflation, which can damage the economy – goods and services can become too expensive, and the pound becomes worth less (not just in people’s pockets, but in international financial markets).

When interest rates are high
Money is more expensive, so people are more likely to save and less likely to borrow, keeping inflation low. This is good for the nation’s long-term economic growth, but when inflation is too low, it can mean salaries grow more slowly. Plus, when interest rates are too high, people and companies can’t afford to borrow for essential things – like buying a house or growing a business.

What’s next for interest rates?
It’s hard to say. The BoE can’t just slash interest rates. It has to do a ‘balancing act’, keeping interest rates low enough to allow healthy, sensible borrowing – and help people manage their existing debts – but high enough to keep inflation under control. It’s a difficult job, not just because there’s a lot of pressure to cut rates dramatically (like the USA’s Federal Reserve did) to make people’s debts more manageable, but because any change to the base rate can take years to have their full impact on inflation, which makes it very hard to measure the effect of previous changes.

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