The Bank of England has raised interest rates by 0.25 per cent to 4.25 per cent today (March 23), following the surprising jump in inflation earlier in the week.

Markets largely expected the change, which marks the 11th rise in interest rates in less than 18 months, as the bank continues to fight inflation. Although inflation was at 10.1 per cent in February, it is now at 10.4 per cent after an unexpected rise due to food prices.

The impact of a rate rise is felt by borrowers — through higher mortgage and loan costs — and in better returns for savers across the UK.

Many economists believed that the Bank of England would pause the interest rate increases while inflation was easing, but that no longer seems to be the case.

On February 1, the International Monetary Fund (IMF) predicted the UK would be the only major economy to plunge into recession this year, with the economy set to contract by 0.3 per cent.

But why does inflation cause interest rates to rise, and how high could they go?

Why are interest rates going up?

Interest rates are rising to try to ease soaring inflation, which is at a 10.4 per cent — well above the Bank of England target of two per cent inflation.

The idea is that, by raising interest rates, households will spend less and this should mean inflation will drop.

Prices have been rising steadily since the easing of Covid restrictions for several reasons.

Pent-up demand meant people spent more money but, because companies are struggling to meet demand, prices are rising. Gas prices have also increased hugely since Russia’s invasion of Ukraine.

The Bank of England has therefore raised interest rates to try to control rising prices.

Increased interest rates make borrowing more expensive, which should encourage people to borrow less money and therefore spend less. This should help curb inflation.

But the Bank of England also does not want to slow down the economy too much — so how much higher could interest rates go?

How high could interest rates rise?

More rate rises could come, but there is a widespread belief that these may end by the middle of the year. The Bank will be keen not to dampen the economy, which is expected to enter recession.

However, that peak is lower than predictions had suggested, when the Government was in some turmoil after its disastrous mini-Budget threw markets into chaos, reports the BBC.

The Bank’s monetary policy committee meets eight times a year to decide interest rate policy.