The U.S. Federal Reserve, euro zone’s European Central Bank and U.K.’s Bank of England have all announced monetary policy moves in recent weeks — and interest rates have once again taken center stage.
The world of central banks and their policies, which include interest rates, may seem abstract — but they affect everyone.
“It can be easy to think that the decisions made by central banks don’t impact the daily lives of normal people, however, the reality is they’re very much likely to,” James McManus, chief investment officer at Nutmeg, told CNBC Make It.
On a very basic level, interest is charged when you borrow money, and paid out when you save money. Interest rates — the rate at which you are charged or rewarded — are set by central banks, like the Fed or Bank of England.
These central banks often raise rates in an effort to cool inflation, and then cut them when inflation is closer to their target. A shift in interest rates affects retail banks and lenders, which then pass them on to consumers.
Pros and cons
How consumers are affected by interest rates varies according to whether rates are higher or lower.
“As a rough rule of thumb, when rates are high, the banks will charge us more for borrowing, and pay a better return on savings. When rates are low, borrowing gets cheaper, but saving gets less rewarding,” Sarah Coles, head of personal finance at Hargreaves Lansdown, told CNBC Make It.
“Borrowing” includes mortgages, student loans, credit card repayments and more. Having higher interest on these payments ultimately means they cost you more.
A real-life example of this is playing out in the U.K., where an ongoing mortgage crisis saw mortgage rates hit a 15-year high in July. Many homeowners are unsure if they can afford the higher payments, while prospective buyers are being put off by the higher cost of borrowing.
This is to be expected, said Russ Mould, investment director at AJ Bell.
“Interest rate rises are supposed to hurt by raising interest bills on mortgages, car loans, credit cards and other finance for borrowers, as those higher bills crimp cash flow and disposable income,” he said.
On the flip side, higher interest rates can boost your savings, Mould added.
“They are, however, potentially good news for savers, as they should, in theory, get higher interest on the cash they have in the bank. That will boost their spending power,” he told CNBC Make It.
Interest rates versus inflation
Interest rates often go hand in hand with inflation (rising prices). Central banks hope that higher interest rates will help bring prices down.
“The theory here is that if more money is spent on borrowing (such as mortgages) and saving is more appealing, people will buy less – therefore reducing demand,” McManus said. “As demand reduces, prices should come down to encourage competition for the reduced level of demand.”
Falling prices might sound like good news, especially in the context of the ongoing cost-of-living crisis.
But interest rate hikes from central banks around the world have also triggered fears of a recession and job losses — both of which are linked to the economic slowdown brought on by higher rates.
Despite these risks, higher inflation can be even more damaging, according to Mould.
“High inflation has not been an issue since the early 1980s so many will have forgotten – or never encountered – its ravages,” he pointed out.
“It does far more damage to far more people that higher interest rates because it hurts the value of everyone’s money by reducing its purchasing power and it affects those who are least well off the most.”
How worried should you be?
Ultimately, the question of how people will be affected depends on their individual situations, Coles said. For example, those with large mortgages will likely be more severely affected by high interest rates, she added.
“However, for someone with no mortgage, inflation feels more painful, and for someone with plenty of savings, higher rates are a bonus,” she said.
Although central bank monetary policy decisions affect everyone’s life in one way or another, it’s important not to worry too much about them, according to McManus.
“Central bank monetary policy goes in cycles, there will be times when interest rates are higher and times when they are lower, the most important thing can often be to plan ahead for both scenarios,” he added.