Inflation and interest rates – What will this mean for you?

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Despite predictions and hopes it would fall, the rate at which prices are rising remained unchanged at 8.7% in May.

In an attempt to slow price rises, the Bank of England has increased interest rates for the thirteenth consecutive time to 5%, the highest in almost 15 years.

What does inflation really mean?

Inflation is the increase in the price of something over time.

The Office for National Statistics tracks the prices of everyday items in a theoretical ‘basket of goods.’ This ‘basket’ represents the general goods and services each consumer is purchasing and is updated to reflect shopping trends. Each month, inflation figures are calculated from how much prices have risen since the same date last year.

Core inflation excludes the price of energy, food, alcohol and tobacco, where prices are generally more volatile. This has risen from 6.8% in April to 7.1% in May, the highest it’s been since 1992. Alongside the headline inflation figure, the Bank of England considers core inflation when deciding interest rates changes.

What’s causing inflation?

Rapidly rising food and energy bills contributed to driving inflation up.

Greater demand for oil and gas after Covid, as well as reduced amounts from Russia, as a consequence of the war in Ukraine, has put further pressure on prices.

Available grain has also been impacted by the war, pushing up global food prices. This squeeze has been compounded in the UK by a shortage of salad and other vegetables in February, which took food inflation to a 45-year high.

Chancellor, Jeremy Hunt – ‘We will not hesitate in our resolve to support the Bank of England as it seeks to squeeze inflation out of our economy, while also providing targeted support with the cost of living.’

The Bank of England aims to keep inflation at 2%, but the current rate is four times higher than this. The traditional response to rising inflation is to put up interest rates, which makes borrowing more expensive. In theory, this should encourage less people to borrow and spend, reducing demand for goods and limiting price rises.

How might this affect you?

Homeowners and people with mortgages (a third of adults in the UK) may see their monthly payments go up and saving rates will increase. The average borrower will be paying around £50 extra per month. They face large increases in repayments when their fixed-term deals come to an end. First-time buyers are also at risk of being priced out of the market, as lending conditions tighten.

Businesses will also borrow less, making them less likely to expand and create jobs, with the potential of cutting staff.

Your business may already have debt. This could be beneficial if on a fixed rate, as the interest rate is likely to be below what’s currently available and below inflation. That means that the loan will be worth less a year from today than it is now. Think of a £1,000 loan in the 1980s against a loan for the same amount today. If you have a variable rate on a loan, then there will be some additional pressure on repayment as interest costs rise.

Whilst lower inflation is the target, achieving it doesn’t mean prices will fall; they just don’t rise as quickly. It’s predicted that inflation will rise to 6% by early 2024, as opposed to the 4% the Bank of England had been aiming for at the end of this year. This means that the cost-of-living for the average person will continue to be challenging, with the hope of improvements in due course.

What can you do?

Here are some steps you might consider taking to protect your long-term finances and combat inflation:

1. Retirement income

Inflation has an enormous impact on how long retirement savings will last. The income that seems more than adequate when you begin your golden years can look less than generous after ten years of inflation, and still worse after twenty. 

A basic level annuity will mean having the buying power of your income eroded every year. An inflation-linked annuity will initially provide a much smaller income, but one that keeps increasing over time. A drawdown pension, where your pension pot remains invested, and you draw down an income as you need it, is more flexible. However, you will still need be careful you don’t run out of cash.

2. Cash savings

Savers should benefit when higher inflation leads to the Bank of England increasing the Bank Rate. Be aware that although the rates offered by savings providers are rising, they have not yet done so enough to come anywhere near inflation.

However, with the Bank Rate forecast to rise further and with savings deals forecast to follow, there could be better deals over the coming months. Shop around for the best deal and avoid locking your savings into a long-term deal, because it could mean missing out on much better rates in the near future.

3. Investment strategy

With inflation, using your cash to buy something which could appreciate in price could be more rewarding than saving.

While inflation erodes the value of cash savings, it actually works to boost the value of some investments, but how should you invest? Bond investment becomes less attractive in times of inflation, as the income provided by bonds is subject to inflation. Investors can protect themselves by buying index-linked bonds, where the interest paid rises in line with inflation.

Some business sectors will suffer during inflationary periods. Oil and mining companies tend to do well as rising commodity prices profit their bottom lines. Utility groups often pay dividends linked to inflation. However, inflation could be bad for others such as retailers and supermarkets, which may lack the ability to increase prices. Luxury goods may well see decreasing sales when households tighten their belts.

4. Low-rate mortgages

To avoid increasing interest costs, which could make buying a home difficult, or even impossible, it makes sense to try and secure the lowest rate you can for your mortgage, fixed for the longest possible period.

5. Consider figures

Although it flies in the face of what the government is trying to achieve with reducing inflation, you may need to consider the pricing of your goods and services. The same fee now would be worth around 92% of what it did a year ago. Considering the squeeze on individuals, do salaries for your staff need to be considered.

Keeping your attention firmly on how your business is performing with good management information (gross profit, net profit and margins for example) is very important.

Let us know if you would like our support in producing good financial information or interpreting the data, so that you can more informed decisions.

6.  Expert help

Managing money in inflationary times can be challenging, but these complexities can be much more manageable if you have an expert to call on.

If you would like to talk to someone about how these changes might affect your finances and what you can do to minimise any negative effects, please get in touch with us. A member of our team will be happy to help…

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