As the oil prices continues to hover around all time high levels we are starting to see genuine concern that the Bank of England may not be able to force through major reductions in interest rates, as many had expected. But how can inflation affect the direction of interest rates?

Historically the weapon of interest rates has been used to either increase economic activity, by reducing rates and making debt cheaper, or increasing rates and making debt more expensive. The cheaper it is to borrow money the more chance of the consumer being in a position to finance their debts and have more money in their pockets, as well as offering more access to funds for businesses looking to invest into their operations.

At this stage of the economic cycle we are seeing consumer demand come under pressure due to the ongoing economic conditions, but we are also seeing businesses increase the price of goods and services directly linked to the price of oil. The increased cost of transporting goods needs to be passed onto the customer at some stage, whether partially or fully, and this is what we are starting to see now. However, there is concern that should interest rates fall to far and the price of oil stays around current levels, we will actually see businesses increase their prices yet further – due in the main to the consumers access to cheaper debt and resulting growth in demand for services / products.

As we see inflation move towards the upper band of the UK government’s target, with many suggesting that it will break through the upper limit very soon, there is potential for a further substantial rise in the rate of inflation as interest continue to move lower. The Bank of England have a very difficult balancing act to figure out, on one hand they need to make cheaper funding accessible to business and the consumer to promote demand, but they also need to ensure that price inflation does not get out of control.

A very very difficult situation to handle!