What Inflation and Rising Interest Rates Mean for Your Money

There have been countless headlines about inflation and the rising cost of living crisis. So, we thought it would be useful to take a step back from the intense media coverage to take a practical look at why the economy is in the state it is and what it means for your personal finances.

What is inflation?

Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living.

So, what has been driving inflation?

Factors contributing to inflation over the last few years include:

• The Covid pandemic – specifically, the lifting of restrictions caused a supply and demand problem.
• The war in Ukraine – which has affected the price of some staple food products.
• Rising energy costs – also exacerbated by the war in Ukraine
• Brexit – which, among other issues, has created higher costs for importing goods.

The current inflation situation

For the first time since August 2022, UK inflation has dipped below double-digit figures but remains stubbornly high at 8.7% in the twelve months to April 2023, according to the Office for National Statistics (ONS). The ONS said the decline was mainly driven by gas and electricity costs remaining stable in April.

The integral link between inflation and interest rates
The base interest rate is the main tool the Bank of England (BoE) can use to help combat inflation. This is why we’ve seen the Bank increase interest rates 12 times in a row.

Typically, higher interest rates mean people will spend less on goods and services, balancing out consumer demand and slowing down inflation.
Inflation and interest rate predictions

In November 2022, the Financial Times reported that “Traders are betting on rates peaking at 4.75% in the summer of next year.” With rates already at 4.5% at the end of May 2023, it’s looking highly likely that this will turn out to be an incredibly accurate prediction.

In fact, forecasts published by This is Money, in May 2023, also suggest that these higher rates of interest will be short-lived. The report states that it’s expected the Bank of England will decrease the base rate to 3% by the end of 2023 and to 2.5% by the end of 2025.

How rising interest rates could affect your cash

Many high street banks have increased the interest they are paying to savers in line with increases to the BoE base rate, in the hope of attracting more savers. Whilst this may initially appear to be good news for savers, at least in the short term, it is important to remember that these higher rates are only being offered due to the high level of inflation. In reality, even with these higher rates they are not keeping pace with inflation and the spending power of cash savings is actually falling in real terms.

While the average interest rates you might find on the high street are currently around 3.7%, should the base rate start to decrease as predicted, so too will the interest you’re getting on your cash savings.

Investing over the long term can help inflation-proof your money

Despite recent stock market turbulence and even with notable falls due to events like the Covid pandemic, the war in Ukraine, and more recently the Cost-of-Living crisis, the stock market has still significantly outperformed both inflation and deposit rates demonstrated in the graph below.

Invest with a long-term horizon

Ideally, you should invest with a long-term horizon. As the graph indicates, historical investment data supports this approach. Investing is not without its ups and downs over shorter periods which is why we recommend investing for a minimum of five years, but 10 years or more is generally encouraged.

We’re here to help

As financial planners, we’ve helped clients weather many economic storms over the years, and that’s something my team and I are proud to continue doing.

Markets may rise and fall, but your investment goals should remain the same, and it’s our job to help you achieve them. For almost 20 years, clients like you have trusted us to provide honest, independent advice in a friendly and professional way.

If you have any queries about anything you’ve read in this update, please don’t hesitate to contact your financial adviser, who’ll be happy to give you all the support you need.