Inflation for May 2022 has now hit a 40-year high, standing at 9.1%. Given that the Bank of England’s (BoE) target is 2%, this represents a big challenge for the UK economy. Trying to counter rising living costs, the BoE has raised the UK base rate four times in six months.
At present, the base rate stands at 1.25%; the highest since the 2008-9 Financial Crisis.
Uncertain times lie ahead, and households are looking for clarity about how all this affects them - and what they should do. Building on our update on inflation and interest rates from last spring, we wanted to offer our latest thoughts on the subject to help you navigate this difficult economic environment in 2022.
What is inflation and the base rate?
To recap, inflation refers to the overall rise in costs in an economy over time. Here in the UK, a common measure is the CPI - Consumer Price Index - which takes a “basket” of 700 goods and services and measures the average price increase, using information from over 120,000 various retailing outlets. The BoE recognises that a gradual inflation rise is good, signalling that the UK economy is growing. However, if prices rise too quickly then it can cause problems.
Higher prices can lead to higher “input costs” for businesses (i.e. buying items from suppliers to make their own products). This eats into their profits unless these costs are passed down to customers, yet doing so may lead to fewer sales. This can be a big problem for industries which have very thin margins, - leading businesses to fail and resulting in rising unemployment.
High inflation is also typically bad for savers, since interest rates from savings accounts can’t keep up. This leads to an increasing “real loss” in the value of cash savings, since £1 can’t stretch as far as it did a year ago.
The BoE can try to “dampen” inflation by raising interest rates. This increases the cost for the UK government to borrow money and (usually) leads banks to raise their own interest rates for customers. This in turn encourages people to save more, if they can get a better return on their regular savings account. Since there is now less spending in the economy, downward pressure falls on the rate of inflation. However, a higher BoE base rate also tends to mean banks raise mortgage rates - leading to greater borrowing costs for homeowners. So, whilst your cash savings may earn more in a high-interest rate environment, in real terms you may be no better off if your mortgage goes up. In fact, you may be worse off.
What’s going on with inflation & interest rates in 2022?
Both inflation and the base rate in the UK now stand at their highest levels in years. Worryingly, the BoE has stated that much of the former is outside their control. Governor Andrew Bailey has warned of an “apocalyptic” inflation rise in 2022, with projections that it could exceed 10% by the autumn. In the 6 weeks preceding the end of April, world wheat prices rose 25% - driven heavily by the conflict in Ukraine, which is a major global supplier. The Russian navy is blockading Ukrainian ships from exporting - leaving huge stores of food stuck in warehouses.
The War has also driven up the cost of energy due to sanctions on Russia, which is the world’s third largest oil producer. Whilst the UK imports relatively little of its energy from Russia (8% of oil and 4% for gas), the situation has driven up global prices - which are then passed on to the UK. This is partly the reason why Ofgem - the UK’s energy regulator - raised the energy cap by 54% (£693) in April 2022. Indeed, costs could rise even further in the autumn, possibly by 20% or even more. It is a grim situation which will put a lot of pressure on many households (in response, the Chancellor announced earlier in the year that a range of rebates would be made available to help offset some of these increased costs).
Will the BoE raise interest rates further if 80% of inflation is out of its control (as the Governor has stated)? This is difficult to answer. The Bank has already raised the base rate four times since December 2021: from 0.1% (an historic low) to 0.25%; to 0.5% in February 2022; 0.75% in April and, most recently, 1.25%. However, the BoE will be wary of raising rates too high. Doing so is likely to halt price growth in the property market, or even reverse it. Moreover, it could cause a sell-off in the equity markets as more “cautious” investors seek the better interest on offer from “safer” government bonds.
Financial planning implications
We understand this is not the most encouraging reading. Yet, as a Chartered financial planning firm, we want clients to see clearly ahead with their eyes open. This will help you prepare your finances and maintain some stability. In light of the above, we suggest checking your emergency fund. Try aiming for a few months’ living costs – your adviser can help you work out how much you need.
Also, consider your mortgage carefully if you own your home. Borrowing too much could create problems later if interest rates continue to rise. For some, it may be worth waiting a bit longer to build up a bigger deposit (to ensure that your budget can cope comfortably with a possible rise in rates). Savers should also think about the cash they are holding. Whilst an emergency fund is wise, your wealth will be disproportionately eroded - in real terms - by inflation if you hold too much in cash (since interest rates cannot keep up with high inflation). As such, you may wish to speak with a financial adviser about other assets and investments which offer a better return*.
*As always with investments, your capital is at risk. The value of your investment can go down as well as up, and you may get back less than you invest.