How are interest rates set?
There are a number of factors that determine interest rates.
Interest rates can be influenced by the supply and demand for loans and credit, and are often lowered or increased on a short-term basis by central banks in an effort to stabilise economies. This, in turn, can have an impact on a wide range of areas including mortgages, borrowing, pensions and savings.
Central banks set short-term target interest rates that will directly impact what interest you earn when you save or are charged when you borrow. In the UK, the most important interest rate is the base rate which is set by the Bank of England’s monetary policy committee, which aims to keep inflation low and steady.
Central banks usually increase interest rates to raise the cost of borrowing and slow down economic activity and inflation. They will cut interest rates to achieve the opposite and stimulate growth.
While very short-term interest rates are set or heavily influenced by central banks, interest rate levels for longer maturities (e.g. 5 years or 10 years) fluctuate constantly to reflect supply and demand dynamics and, most importantly, expectations of central banks’ future decisions and growth and inflation outlook. The shorter the maturity, the more important central banks’ actions are in explaining interest rates. The longer, the more important other factors such as economic growth and inflation become.