You will have seen "base interest rate" hikes quite a bit in the news over the last couple of months https://www.theguardian.com/business/2023/mar/23/bank-of-england-raises-uk-interest-rates-inflation, so it is worthwhile to look a bit deeper into what it is, how it works, and what it means for the economy and for individuals and consumers.

Understanding Base Rate Interest Rates

In simple terms, it is the rate at which a central bank, e.g., the Bank of England or the US Federal Reserve, charges banks (and other financial services companies) for loans. It is usually set by a committee of experts that meets regularly, typically every four to six weeks, and publishes its decisions immediately after they have been made https://www.bankofengland.co.uk/monetary-policy-summary-and-minutes/2023/march-2023. In the UK, this committee is called the Monetary Policy Committee (MPC), which sets the Bank Rate. It also oversees other interest rates, such as the repo rate, and manages monetary policy instruments such as open market operations (buying/selling of currency, bonds, or other assets) and minimum reserve requirements (deposits that banks are required to hold with the central bank). Most central banks are run independently but have targets set by their governments—for example, the European Central Bank’s target is to maintain price stability to preserve the purchasing power of the euro. Currently, this is set at 2% inflation over the medium term https://www.ecb.europa.eu/mopo/strategy/pricestab/html/index.en.html. This also helps to give some guidance to outside observers (or “the market”) on which interest rate levels to expect from the committees.

Impact on Consumers

Banks are expected to pass on changes in base rates to their customers—in the end, they make money like any other business: buy low, sell high. You might guess which interest rate movements will get passed on more quickly to consumers, but overall, interest rates for loans, deposits, credit cards, and lots of other products will be amended after an interest rate decision. You might have received one of those letters or emails that no one really reads, informing you about changes in the interest rate applied to your account.

Balancing Inflation and Economic Growth

Borrowing money will become more expensive, which has a dampening effect on investment and spending, thereby reducing inflation. It is a tricky balance for central banks: raise interest rates too high, and you risk pushing an economy into recession; not doing enough can allow inflation to continue. You could also argue that the current drivers of inflation (e.g., energy costs) are outside the sphere of influence of a central bank, so it can only treat the symptoms. If the cure includes substantial investments, e.g., into green energy, higher interest rates might be counterproductive.

Effect on Savings and Bank Refinancing

Higher interest rates attract more savings and deposits, which offer banks the opportunity to refinance themselves on the market rather than through the central bank.

Higher Discount Rates and Net Present Value

On a technical level, you will apply a higher discount rate when calculating the net present value of an investment or a project. That means that their present value will be smaller compared to an environment with lower (or even zero) interest rates.

Impact on Mortgages and House Prices

Interest rate increases mean that mortgages get more expensive—house prices tend to fall if interest rates go up. Interest payments will take up a higher proportion of a fixed housing budget, so there is less money to spend on the purchase price of the property itself. It might also mean that marginal buyers are dropping out of the market, so there is less demand overall, driving down prices.

Effect on Share Prices

Share prices tend to fall when interest rates rise, as the cost of capital goes up, making it more difficult and expensive for companies to finance growth projects. It also means that revenues are predicted to go down, as other companies and consumers will have to reduce their spending due to higher financing costs. Higher interest rates also mean future discounted valuations are lower, as the discount rate used for future cash flows is higher. However, this is not true across the board. Not surprisingly, shares of financial services companies tend to rise as their profits are expected to go up; as consumers are thought to reduce spending, discounters and budget companies are expected to fare better as well.

Impact on Bond Prices and Commodities

Bond prices tend to fall when interest rates rise. It may seem counterintuitive, but if you look at issued bonds with a fixed coupon (regular interest payment), you will see that their overall value will fall when calculated with a higher discount rate. New bonds will carry higher interest payments and will thus be more attractive to investors.

An increase in the interest rate reduces firms' demand for holding inventories (as they become more expensive with a higher discount rate) and therefore lowers commodity prices. As customers are expected to lower their demand, companies might also plan to reduce their output, requiring smaller inventories. On the other hand, the inflation that triggered interest rate hikes will also increase the prices of certain commodities, e.g., oil.

Effect on Venture Capital and Tech Investments

Venture capital and tech investments will suffer, too. Their NPV will be lower, making investments less attractive, especially when compared to alternatives. If "boring" government bonds or bank deposits offer 3% or even more, you might not opt for that risky start-up investment, especially if you are a pension fund.

Impact on Pensions

Pensions should fare better, as higher interest rates mean that payouts from annuities will be higher, and pension providers will achieve higher returns, but NPVs of pensions will be lower.

Effect on Cryptocurrency

Cryptocurrencies, with their wild swings, are an interesting story in themselves. Higher interest rates tend to lower crypto prices, since much of this retail speculation is traded on margin and/or with disposable income, which will be reduced by higher interest rates.Note that all of the above describes overall trends, and individual assets can perform better in periods of high interest rates. Some of these trends can also be interdependent. The outcome will also depend on how long this period of high interest rates will last. Short-term interest rates at the moment are higher than long-term rates https://www.statista.com/statistics/1058454/yield-curve-usa/ (an inverted yield curve), so there is some expectation in the market that interest rates will plateau soon https://data.oecd.org/interest/short-term-interest-rates-forecast.htm and might fall again in the not-so-distant future. As ever, look at real interest rates (i.e., take inflation rates into account) for analyses and decision-making. While a base rate of 4% and above makes interesting headlines, going back to levels not seen for 15 years, current inflation rates are even higher, especially in the UK, so interest rates might not be that shocking after all.