The UK’s largest banks have all recently announced a rise in interest rates, with Barclays and others pulling their cheapest mortgage deals off the market since October 2021. At the same time, headlines have been broadcasting about rising UK inflation in the months following the summer, after COVID-19 lockdown was lifted.
In the UK, the Bank of England (BoE) sets the target rate of inflation (the rate by which goods and services, overall, rise in the economy). The BoE aims for 2% per year for inflation, which many economists regard as the “sweet spot” for rising prices. This might sound counterintuitive, but a moderate rate of inflation is often seen as positive since it helps to drive economic growth - e.g. more jobs and a rising overall standard of living.
However, if prices fall sharply (deflation) then people’s spending power also falls, often resulting in lower economic growth. Also, inflation which rises too much - say, by 5% or more - can lead to “hyperinflation”, which can send prices spiralling out of control. This happened in Germany in the 1920s during the Weimar Republic, when the price of a loaf of bread rose from 250 marks to 200,000m in just eleven months.
Fortunately, the UK presently appears nowhere near the extremes of deflation or hyperinflation. However, inflation has been rising in 2021. In August, it rose at the fastest pace since the BoE gained independence (in 1997), to 3.2%. Many factors lie behind this, but a powerful one is likely to be the fact that pent-up demand for goods and services has been released since COVID-19 restrictions were lifted following the UK winter wave. This is reflected in the areas where prices seem to have risen the most such as restaurants, transport and recreation. Currently, the BoE is forecasting that inflation could rise to 4% by the end of 2021, and could even reach 5%.
One of the BoE’s most powerful tools to help control UK inflation is its base interest rate, which it can alter. Interest rates have been at historic lows since March 2009, when it stood at 0.5%. Since then, rates have fallen further and now, in 2021, stand at 0.10%; the lowest they have ever been. Keeping rates low can, arguably, encourage spending in the economy - especially since savers can no longer access strong interest rates from regular savings accounts at banks (which set their own interest rates based on the BoE base rate). Moreover, low interest rates allow people to borrow money more cheaply. Mortgage deals, for instance, tend to offer lower interest rates when the BoE base rate is lower.
Now that inflation is rising, however, the BoE is facing increasing pressure to raise the base rate to stop the UK economy “overheating”. This could lead banks to raise their own interest rates, which could “cool down” the economy by encouraging more people to save, rather than spend. Rising interest rates would likely also lead to higher monthly mortgage costs for homeowners, leading to less disposable income to buy goods and services.
The key question, however, is whether the current inflation rise is “transitory” or more permanent. Until now, the BoE appears to have been sitting still, not altering the base rate in hopes that inflation will naturally cool down as the UK economy readjusts to “life after lockdown”. However, many analysts believe that the BoE may be forced to raise the base rate to 0.25%, or even 0.75%, by the summer of 2022.
Rising inflation also has a longer-term impact on your financial plan since it erodes the spending power of the income that is derived from your investments, and the growth of your investments in “real terms”.
What do these movements in the UK economy mean for your wealth and finances? Of course, rising inflation means rising prices - which could result in higher monthly household bills. There are signs of this already with the cost of food, drink and (more recently) petrol going up since the summer. However, rising inflation also has a longer-term impact on your financial plan since it erodes the spending power of the income that is derived from your investments, and the growth of your investments in “real terms”.
For instance, if UK inflation meets the BoE target of 2% per year and your portfolio rises by 8%, then in “real terms” its value has increased by 6% (excluding fees). However, if inflation goes up to 4% or 5%, then your real returns could fall to 4% or 3%, respectively. For certain investments which offer a lower return (e.g. gilts, or UK government bonds), this could result in a “real terms loss” if the interest rate falls below the rate of inflation. In light of this, many people are putting more money into “higher risk” investments to try and get a higher return (e.g. the stock market), which could beat inflation. This may be fine for some investors, such as those with a longer investment horizon and higher risk tolerance. For many investors, however, this may not be an appropriate strategy, because there is no guarantee that higher risk investments will beat inflation and you could get back less than you invest.
Should the BoE raise interest rates, then this could also have a big impact on your immediate and long-term finances. In the short term, it might lead to a higher monthly mortgage payment if, say, you are on a standard variable rate with your lender. If you hold cash savings, then you might see slightly higher returns from the interest rate on your savings account. Yet perhaps the biggest impact could be on the stock market. After all, if investors feel that they can get a better return on “safer” investments such as gilts, then this could lead to a big sell-off. Depending on your investment goals, risk appetite and horizon, such a scenario could be a bad or good thing. Consider speaking with your financial adviser if you are at all concerned about how interest rates and inflation may affect your portfolio and financial plan in the months ahead.
Note: Investments and the income from them can go down as well as up and is not guaranteed at any time. You may not get back the full amount you invested. Information on past performance is not a reliable indicator for future performance.