How interest rates fight inflation

The rate of inflation is defined as the pace at which prices rise, generally determined by the balance between supply and demand for goods within the economy. A rise in demand will tend to lead to an increase in inflation as the economy's money seeks fewer goods and services which, in turn, raises prices. A fall in demand triggers a reduction in inflation. In October 2008, the UK inflation rate was 4.5%, meaning prices overall were 4.5% higher than a year previously.

Movements in interest rates affect overall demand as they determine the amount of credit and cash available to be spent within the economy and thus affect the rate of inflation.

In mid-November 2008, the Bank of England succumbed to pressure and reduced the rate of interest by a whole 1.5%, although it was thought they had considered an even bigger reduction. This is the official short-term interest rate, officially known as Bank Rate but often referred to as the base rate. The Monetary Policy Committee at the Bank of England felt this was a necessary move in order to meet inflation targets set by the Government. The Committee's objective is to deliver price stability i.e. low inflation. The current target is currently set at 2% but is reviewed annually by the Exchequer and announced in the annual Budget statement. In October, the UK inflation rate exceeded the Government target and also the provisional figure for the whole of the European Union (3.7%).

This reduction in base rates is expected to prompt a fall in the bank rates to customers, although not all have agreed to pass on the full reduction. Usually when banks lower their interest rates, repayments against loans including mortgages and credit cards for households and businesses are lowered. This frees up money to spend on other things, which increases demand within the economy, and in turn encourages businesses to increase their prices to meet demand, thereby leading to an increase in inflation.

Any reduction in interest rates has a harsh effect on savers, as the interest rates they earn on their deposits are reduced, which tends to discourage saving and encourage spending, leading to a reduction in inflation.

Conversely, a rise in base rates from the Bank usually leads to a rise in the bank interest rates, which reduces the available money people have to spend, dampening demand and forcing a reduction in prices to enable businesses to sell more.

Interest rate fluctuations have important consequences for business and consumer confidence. Usually, an increase in interest rates will lessen confidence and a cut will improve it. Lower economic confidence reduces the propensity of businesses and consumers to spend money which reduces demand. The consequential lack of money moving around the economy will tend to slow it down. Lower rates encourage borrowing and therefore produce the opposite effect.

Changes in the interest rates occasionally have some immediate effect through confidence, but it may take a minimum of one year before the full effect can be felt by the economy, i.e. an increase in demand, and potentially up to two years for a change to be fully reflected in inflation. These "lags" are variable and uncertain.