Interest Rates

Introduction

If you learn only one idea in economics, make it this one: interest rates are the price of money, and that price sets the value of almost everything else.

A mortgage, a savings account, a government bond, a growth stock, the pound in your pocket — all of them are quietly repriced whenever interest rates move. When the Bank of England changes a single number, the effect fans out through millions of loans, savings pots and investment decisions, and eventually reaches the shelves of the supermarket and the balance of your pension.

Most people meet interest rates through a mortgage or a savings account and never look further. Investors cannot afford that. Rates are the gravity of financial markets — the force in the background that pulls on every asset price at once. This article explains what an interest rate actually is, who sets it and why, and exactly how a change travels from a committee room in London to your portfolio.

Quick Definition

An interest rate is the cost of borrowing money — or equivalently, the reward for lending it — expressed as a percentage per year. The base rate, set by the central bank, is the anchor from which nearly all other rates in the economy are priced.

Everything else in this article is an unpacking of that one sentence.

Money Has A Price

We are used to the idea that goods have prices. So does money itself. If you want to use someone else's money for a year, you pay for the privilege — that payment, as a percentage of the amount borrowed, is the interest rate.

Two forces sit underneath it:

• Time. A pound today is worth more than a pound next year, because you could invest today's pound and have more by next year. Interest is the price of that waiting.
• Risk. Lending to a rock-solid borrower is cheap; lending to a shaky one is dear. The riskier the loan, the higher the rate demanded to compensate for the chance of not being repaid.

So every real-world interest rate is really the base rate plus a premium for the extra time and risk involved. A 30-year mortgage costs more than an overnight loan between banks. A loan to a struggling company costs more than a loan to the government. But all of them are built on top of the same foundation: the rate set by the central bank.

Who Sets Interest Rates?

In the UK, the foundation rate is the Bank of England base rate (officially, "Bank Rate"). It is decided eight times a year by the Monetary Policy Committee (MPC) — nine economists who vote on whether to raise, hold or cut.

The base rate is the interest the Bank of England pays commercial banks on the reserves they hold with it, and charges them to borrow. Because every high-street bank can earn (or pay) that rate at the Bank of England, none of them will lend to you for less, or pay savers much more than they must. The base rate therefore becomes the gravitational centre for the whole system: mortgage rates, savings rates, business loans and credit cards are all quoted as "base rate plus a margin".

Other countries have their own versions. The United States has the federal funds rate, set by the Federal Reserve. The eurozone has the European Central Bank's policy rates. The mechanics differ slightly, but the principle is identical: one committee sets one anchor rate, and the entire economy prices off it.

Why Rates Move: The Inflation Target

The Bank of England does not change rates on a whim. It has a job set by Parliament: keep inflation at 2%. (See Inflation for why that number, and why steady low inflation matters.)

The logic is a thermostat:

• When inflation is too high, the economy is running hot — demand outstrips supply and prices climb. The Bank raises rates. Borrowing becomes dearer, saving more rewarding, so households and firms spend less. Cooler demand eases the upward pressure on prices.
• When inflation is too low or the economy is weak, the Bank cuts rates. Cheaper borrowing and poorly-paid savings encourage spending and investment, warming the economy back up.

This is called monetary policy, and interest rates are its main tool. The tragedy and the skill of it is timing: because a rate change takes many months to work through the transmission mechanism above, the MPC must act on a forecast of where inflation is heading, not where it is today. Move too late and inflation runs away; move too hard and you tip the economy into recession.

Interest Rates And The Price Of Everything

Here is where rates stop being a mortgage story and become an investing story. Almost every asset is valued as the sum of the cash it will pay you in the future. Interest rates set how much those future pounds are worth today — a process called discounting.

Turn the rate up, and future money shrinks in today's terms. Turn it down, and future money swells. That single mechanism explains an enormous amount of market behaviour:

• Bonds pay fixed amounts. When rates rise, newly issued bonds pay more, so older, lower-paying bonds must fall in price to compete. Bond prices and interest rates move in opposite directions — a relationship explored fully in Bonds.
• Shares, especially in fast-growing companies, are valued on profits expected years ahead. A higher discount rate slashes the present value of those distant profits, which is why rate rises tend to punish growth and technology stocks the hardest.
• Savings and cash become genuinely attractive when rates are high — a risk-free 5% from a savings account raises the bar every riskier investment must clear.

This is why traders hang on every word from the Bank of England and the Federal Reserve. A rate decision is not just news for borrowers; it resets the discount rate applied to every asset on Earth.

Real vs Nominal Rates

A rate quoted on a savings account or a bond is the nominal rate — the headline number. But what actually matters for your wealth is the real rate: the nominal rate after subtracting inflation.

Real rate ≈ nominal rate − inflation

Suppose your savings account pays 5% while inflation runs at 4%. Your money grows by 5% in number, but everything you might buy has become 4% dearer, so your true gain in purchasing power is only about 1%. If inflation were 6% instead, your "generous" 5% account would be quietly losing you about 1% a year in real terms.

Central banks think in real terms, and so should you. A high nominal rate during high inflation can be less rewarding than a low nominal rate during low inflation. Always ask what a rate buys, not just what it says.

The Rate Cycle

Rates are not set once; they move in long cycles that shape the entire investing climate.

During a hiking cycle, borrowing gets progressively dearer, cash and bonds grow more attractive, and expensive growth stocks often struggle. During a cutting cycle, the reverse tends to happen — cheap money flows toward riskier assets, and shares frequently rally in anticipation. No two cycles are identical, and markets often move before the rate does, pricing in what they expect the Bank to do next. But the broad rhythm — tighten, peak, loosen — repeats across decades.

Common Misconceptions

"The government sets interest rates." In the UK, the Bank of England is operationally independent — the MPC decides, deliberately insulated from short-term political pressure. The government sets the target (2% inflation); the Bank chooses the rate to hit it.

"Rate cuts are always good for me." Cheaper mortgages, yes — but also feebler savings rates, and cuts usually happen because the economy is weakening. The cause is rarely cheerful.

"Higher rates are bad for the stock market, full stop." Over-simplified. Rates rise for a reason — often a strong economy — and some sectors (banks, insurers) can benefit. The relationship is real but not mechanical.

"The base rate is the rate I'll pay." No — it is the floor the system is built on. You pay the base rate plus a margin for your own risk and the loan's length. When the base rate is 5%, your mortgage might be 6% and your credit card 24%.

Real-World Application

Picture a household with a £200,000 tracker mortgage, priced at "base rate + 1%".

• With the base rate at 1%, they pay 2% — roughly £850 a month on a 25-year repayment mortgage.
• If the Bank raises the base rate to 5%, they now pay 6% — roughly £1,290 a month.

That extra ~£440 a month is money no longer spent in shops, restaurants and holidays. Multiply it across millions of mortgages and you see the transmission mechanism at work: the rate rise cools spending, which is exactly what the Bank intended when fighting inflation — even though it lands as real pain on real budgets.

Now flip to the same family's savings. At a 1% base rate their easy-access account paid almost nothing; at 5% it might pay 4.5%, finally rewarding the saver. Every rate decision creates winners and losers at the same moment — borrowers and savers sit on opposite ends of the same lever.

For an investor, the lesson is to watch the direction and expectation of rates, not just today's level. Markets are forward-looking machines: by the time a cut arrives, shares may already have risen in anticipation of it.

Key Takeaways

• An interest rate is the price of money — what borrowers pay and lenders earn, as a percentage per year.
• The Bank of England's MPC sets the UK base rate, the anchor from which mortgages, savings, loans and credit cards are all priced as "base rate plus a margin".
• Central banks move rates to keep inflation at target — hiking to cool an overheating economy, cutting to warm a weak one — accepting a long lag before the effect shows.
• Rates set the discount rate on future cash, so they reprice nearly every asset: bonds move inversely to rates, and growth shares are especially sensitive.
• What matters is the real rate (nominal minus inflation), not the headline number.
• Rates travel in cycles — tighten, peak, loosen — and markets usually move ahead of the decision.