Understanding interest rates

A national newspaper is reporting fears of an interest rate hike, but no explanation is offered as to why it should be feared.

The base lending rate of the Bank of England is a price.  It is the price of money, or rather the price of borrowing money.  It is really not much different to the price of rhubarb, although you might not think it from the way it is commonly reported.

A key difference between the price of money and the price of rhubarb is that we can live without rhubarb, although some of us might prefer not to.  Nevertheless, the difference can be exaggerated.

When interest rates go up, people with mortgages and other loans typically pay more interest as a result.  Paying more money in interest leaves them with less money to buy other things such as mobile phones.  Therefore a rise in interest rates might result in a fall in the sale of mobile phones.

Then again, higher interest rates typically also result in people with savings earning more money in interest on their nest eggs.  I say typically, because not all bank accounts pay interest.  When savers earn more interest, then they have more money to spend on things such as mobile phones, and so a rise in interest rates might result in an increase in the sale of mobile phones.

Then again, if the price of rhubarb rises, then people who buy rhubarb will typically have less money to spend on other things such as mobile phones, and therefore a rise in the price of rhubarb might also result in a fall in the sale of mobile phones.  On the other hand, people who buy rhubarb might react to a rise in the price of rhubarb by buying apples instead, and so sales of mobile phones might be unaffected.

Prices are set for a reason.  Someone once joked that anyone can be an economist if they can say the words supply and demand.  Basically, when demand for rhubarb increases, greengrocers can increase the price so as to dampen that demand to a point at which supply matches demand.  Farmers can then grow more rhubarb in a bid to cash in on the higher prices, and the increased supply which ensues can allow the price of rhubarb to fall.

The raising or lowering of the base lending rate is a response to the supply of money and the demand for it.  Higher interest rates discourage people from borrowing too much but encourage saving.  More saving makes more money available for borrowing, and so the interest rate can fall to stimulate demand for borrowing.

Anyone who wants the level of interest rates to either rise or fall should ask themselves why they want it.  It is easy for people with mortgages to want an interest rate cut for entirely selfish reasons, just as it is equally possible for people who save to want an interest rate rise for entirely selfish reasons.  Ideally though, political debate should rise above self interest.