Inflation & interest rates explained

Inflation is a key concern in economies across the globe, with a direct impact on the cost of living and interest rates. As of May 2026, inflation (based on the Consumer Price Index) stood at 2.8% in the UK.

Taking steps to understand how inflation and interest rates in the UK impact the economy and individuals could help improve your financial wellbeing. On this page, we look at the definitions of inflation and interest, how they work together and how they may affect you.

Inflation is the rate at which prices are rising, which also makes it the rate at which the value of money is falling. For example, if the cost of a £12 cinema ticket rises by 50p, then cinema ticket inflation is 6%.

As well as goods like food and fuel, inflation applies to services too, like having your windows cleaned or getting a haircut. Inflation targets are set low enough that the average consumer won’t notice an increase from year to year if the target is achieved. However, in the long term, these price rises will have an effect on how valuable your money is and what you can buy with it. This is also known as purchasing power.

In the UK, the target inflation rate is 2%. The Bank of England, which is the central bank in the UK, aims to achieve this via its monetary policy.

Inflation is calculated by comparing the price of a set list of goods and services against the previous year’s prices. This list of goods and services is called the ‘basket of goods’.

The basket of goods is a list of around 180,000 products and services that the average consumer purchases. The prices of these products and services are put into the consumer prices index (CPI), the most common measure of inflation.

The basket of goods  is reviewed every year because consumer spending habits change, and different things become popular or in demand. This table shows the difference between the basket of goods in the 1940s vs 2025:

The inflation rate is used by government bodies to make many different financial decisions, ranging from pension adjustments to the cost of train fares. Economists use inflation to help determine the performance and outlook of an economy.

A small amount of inflation is widely considered to be a good thing and a sign of a working economy. However, if prices increase suddenly, it might mean that the economy is being challenged.

So, to strike the right balance, the Bank of England’s inflation target sits at around 2%.

Most of us are affected by increasing prices, but you’re likely to feel the increases more acutely if you earn a low wage or don’t have an emergency fund.

For example, if your salary rises by less than inflation, the purchasing power of your wages will decrease because the value of goods and services will increase at a faster rate than your income.

Some people’s income increases in line with inflation. In these instances, purchasing power should remain about the same as the cost of goods and wages increase at roughly the same rate.

Due to the relationship between inflation and interest rates, inflation can also affect your savings and pension pot.

The Bank of England base rate is the most important interest rate in the UK. It dictates how much the Bank of England charges other banks and lenders when they borrow money. This directly influences the interest rates banks offer you for savings accounts and mortgages.

The Bank of England uses the base rate to help control the economy and manage inflation. By raising the rate, the Bank encourages saving and discourages borrowing. By lowering the rate, the Bank encourages spending. As of June 2026, the base rate is set at 3.75%.

In theory, inflation and interest rates directly affect each other. History shows us that when interest rates are low, inflation tends to rise - and vice versa.

When the cost of living increases sharply, the Bank of England might consider increasing interest rates. Higher interest rates   often lead to higher borrowing costs and higher savings rates, which means people may choose to save money, using accounts like fixed rate bonds rather than apply for loans or spend on credit cards.

This shift should theoretically lead to less demand for goods and services and, as a result, lower prices. Lower prices means lower inflation, which then leads to lower interest rates and consumers spending more. However, inflation is influenced by many factors outside of a central bank’s control, including global conflict and political instability, which means higher interest rates don’t always lead to lower inflation. 

Higher rates of inflation can decrease the value of your pension.

This is similar to how inflation affects our savings. For example: if your pension grows by 6% in a year but inflation is 3%, your pension’s value will only increase by 3% in real terms because of the rise in prices and subsequent reduction in purchasing power.

Another way inflation can affect your pension is through the government’s triple lock policy. This policy means that the state pension increases each year by whichever is highest out of the following: 2.5%, inflation as calculated by the consumer price index (CPI), or average salary growth.

To protect your purchasing power, you need a savings account with an interest rate that beats or matches the rate of inflation.

When choosing between fixed and variable rates, you should consider your personal inflation risk. A fixed rate locks in your return for a set period. This can be beneficial if inflation drops and the Bank of England lowers the base rate. A variable rate can change at any time. This might suit you if you expect inflation and interest rates to go up in the near future.

Banks adjust their savings rates based on the Bank of England base rate rather than inflation itself. However, savings rates sometimes rise even when inflation is stable. This happens when banks actively compete to attract your deposits to fund their own lending activities.

Current forecasts suggest UK inflation will remain slightly above the 2.00% target for much of 2026. Because of these ongoing economic pressures, the Bank of England has kept the base rate steady at 3.75%. While some analysts predicted earlier rate cuts, these have been delayed.

This environment means you can still find competitive savings rates across the market. 

Raisin UK gives you access to a wide range of fixed term and easy access accounts from our partner banks. You can open and manage multiple accounts through a single registration. Your eligible deposits are protected up to £120,000 per bank and per depositor under the Financial Services Compensation Scheme (FSCS).