The Bank of England has announced another interest rate rise in an attempt to control even higher levels of inflation and bring down the cost of living.

Despite inflation falling slightly in November, the Bank of England has announced that interest rates are increasing again to 3.5%. We look at what’s been happening and, importantly, what it means for your savings and investments.

First things first – what are interest rates?

Interest rates tell you how high the cost of borrowing is, or how high the rewards are for saving.

In this article we’re specifically talking about the interest rate set by the Bank of England – commonly known as the base rate. In the US, the base rate is set by the Federal Reserve and in the Eurozone by the European Central Bank.

How does the base rate affect you?

The rate that a central bank, such as the Bank of England in the UK, charges to commercial banks has an impact on what they charge you for loans and mortgages, and also what interest rate you get for saving with them. So the cost of borrowing and the returns on your savings depend to a large extent on the interest rate set by the Bank of England.

If the base rate rises, banks have to get money at a higher rate, meaning the cost of mortgages and other loans usually rises too – which isn’t good news. On the other hand, you should be earning more interest on your savings. It’s worth shopping around though to make sure you’re definitely getting the best interest rates on your savings accounts as banks don’t always pass on the full interest rate rise to savers.

The base rate plays a crucial role in economic policy too

The Bank of England uses the base rate as a tool to control inflation. The theory is the higher the base rate, the more incentive individuals and businesses have to save rather than borrow money: they’ll be getting higher returns from their savings but have to pay more for any loans. So if inflation gets too high, the Bank of England is likely to increase the base rate to encourage us all to spend less and to save more. In turn, it hopes this will help to bring price rises – inflation – back under control.

And that’s just what’s happened – inflation has been rising

The Bank of England currently has an inflation target of 2%. But inflation has exceeded that since August 2021 – and currently remains in double figures, despite easing slightly in November.*

It isn’t only the UK which has experienced rising inflation – the rising price of commodities, including oil, has led to upward inflationary pressures globally.

The Bank of England believes there’s still “a long way to go” in the battle against inflation. So it has raised the base rate by another 0.5%, meaning interest rates are now at their highest level since December 2008.

The Bank's Monetary Policy Committee meets eight times a year – roughly once every six weeks. And we can expect more rate increases in 2023 as Andrew Bailey, governor of the Bank of England, has said that “returning inflation to the 2% target remains our absolute priority”.

What does this mean for savings?

While the interest rate hike may be bad news for homeowners without a fixed rate mortgage, savers could see a boost to their returns. The interest rate hike is likely to have a positive impact on savings accounts, with many banks upping their offerings. But it’s important to remember that the interest you earn on cash savings will still be well below the rate of inflation, so the value of your money is decreasing in real terms.

Colin Dyer, financial planning expert at abrdn said: “With undeniable financial pressure on cash-strapped households right now, another hike to interest rates will come as a further blow for borrowers.

“The Autumn Statement did almost nothing to squash money worries for most, especially with tax freezes leaving some facing the prospect of higher tax bills for many years to come. On top of this, eye-watering inflation isn’t going to ease anytime soon, so those that are able to save must do what they can to protect their future finances.

“As we approach the costliest time of the year, many will be looking to make cutbacks. On top of this, those able to save or invest should seek to use all the tax reliefs and allowances available. Remember too that professional help is out there, whether you need support with bills and debt, or help with planning for your future finances.”

What does this mean for investments?

When it comes to your investments – rising interest rates are usually a negative for stock markets as they suggest a period of slowing economic activity will follow. But the good news is that the current rate rises were expected so may have already been priced in by global markets. That means you shouldn’t see too much movement in markets on the back of this rise in interest rates.

When it comes to bonds, higher interest rates reduce bond yields and make those less attractive. This can have a negative impact on the future earnings of companies, especially those that rely on borrowings. So it’s possible that some company share prices may suffer as a result too.

At times like this it’s important for investors to remain calm and not react to short-term economic events. Take a look at our article on market volatility and investing for the long term to find out more about looking at the longer-term returns that investments have the potential to give rather than panicking about short-term falls.

There’s help and support if you need it

If you want to keep up to date with what’s happening in global markets, you can read regular market commentaries from our investment experts, Thomas Watts and Craig Hoyda.

If you’re not sure how market and economic events may affect your investments, or are concerned about the impact of the interest rate hike, you could consider speaking to a financial adviser. If you don’t already have an adviser, you can book a free, no-obligation call with one of our financial planners.

*Source: Office of National Statistics, December 2022.

The information in this article should not be regarded as financial advice. Please remember that the value of investments can go down as well as up and may be worth less than was paid in. Information is based on abrdn’s understanding in December 2022.