Finding the ‘real’ interest rate

The headlines are full of stories about rising interest rates and their impact but it is the real interest rate that matters.

Interest and inflation interact in a variety of ways. Inflation affects the rate of interest, known as the real interest rate.

This is because when the value of money decreases due to inflation, lenders may charge a higher rate of interest to compensate for the decreased value of money.

Similarly, when inflation is low, lenders may lower their interest rates to encourage borrowing.

Consumer confidence is another factor that affects the real interest rate. When people feel more optimistic about their finances and the economy as a whole, they are more likely to borrow money or invest, thus driving up demand for loans and pushing up interest rates.

On the other hand, if people feel less confident about their finances or the economy overall, they will be less likely to borrow or invest, leading to lower demand for loans and pushing down interest rates.

The Bank of England (BoE) also has an influence on this dynamic by setting monetary policy interest rate targets that affect market-wide interest rates.

When they cut their target rate, also known as the base rate, this encourages lending which puts downward pressure on market-wide borrowing costs.

Conversely when they raise their target rate borrowing costs increase due to increasing loan demand from borrowers competing with each other for limited funds.

Understanding changes in interest rates can be critical when taking on new debts, but equally, it can affect your future saving plans.

At the moment, the current economic effect of inflation is suppressing many saving rates, despite the base rate increasing.