Interest rates are reducing – But what are they, how are they set and why do they matter?

What are interest rates?

Interest rates, along with tax rates and foreign exchange rates, are one of the key levers the authorities have to manage the UK economy. The health of the economy affects us all, so the manipulation of these rates is important.

When the media refers to interest rate changes it is normally referring to the Bank of England base rate. This is the interest rate the Bank of England (i.e. the UK’s central bank) charges commercial banks for money borrowed overnight which is used to balance their books. As consumers we do not pay this rate, but it has a knock-on effect on the borrowing and lending rates set by high-street banks and building societies.

How are interest rates set?

Since 1997 base rates have been set independently by the Bank of England, free from direct political influence. The government sets the Bank of England a price inflation target, and it is the Bank’s responsibility to manage interest rates to meet this target. The current target is to achieve a long-term inflation rate (consumer price inflation or CPI) of 2%.

The Bank of England’s Monetary Policy Committee (MPC) meets each month to agree the interest rate. It is a nine-person committee, chaired by the Governor of the Bank of England. Five of the MPC members are senior Bank of England employees and the other four are external experts, appointed by the Chancellor of the Exchequer.

At each MPC meeting, the members consider various wide-ranging economic factors and vote on the proposed interest rate following a recommendation from the Governor. A straight majority vote determines the MPC’s decision and this is published the following day at 12 noon. You can see these publications here 

Why do they matter?

The activities of the MPC may appear technical and beyond many of our daily lives, but their decisions affect all of us. 

A lower base rate is likely to encourage high-street banks and building societies to lower the interest rates they offer to us. This would lower the income we receive on our savings but would also lower the interest we pay on any debts we hold. 

Lower interest rates could also impact foreign exchange rates. A lower interest rate could make Sterling a less attractive currency to investors so reduce the value of Sterling relative to other currencies. This would increase the price of imports and reduce the price of exports. As a trading nation, a change in the exchange rate is significant for the UK.

What does this mean for you?

As outlined above, a change in interest rates could affect various elements of our financial lives. It is impossible, however, to quantify the size of these impacts in advance. Regardless, a good first step is to be prepared – to understand the potential impact and consider how it could affect your financial position.

Aviva’s Budget Calculator could be a good place to start. By considering the various elements that make up your income and your outgoings, and understanding the directional impact a change in interest rates could have on these, you will be a positive step closer to being prepared for any changes.

You can see the Aviva Budget calculator here:

You can also mark your diary for upcoming Bank of England decisions. These are published on their website.  

Finally, try not to panic. Calm and considered actions are often better when it comes to managing our finances.

For more information on how interest rates can affect savers and borrowers finances, read 'Interest rate changes - what impact do they have on people's finances?'

AR01738  08/2016

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