The interest rate-inflation effect

Are you a home-owner with a mortgage, a retired medic trying to live off your pension income, or simply a saver trying to put funds aside for that special occasion or rainy day? Whoever you are, the tendrils of inflation touch us all in some shape or form.

With inflation and interest rates so inextricably linked, how does the Bank of England’s recent forward guidance on interest rates financially affect you and the value of your hard-earned money?

The interest rate - inflation effect

Inflation influences the interest rate we get on our savings and the rate we pay on our mortgages. It also affects the level of state pensions and benefits we get.

What is inflation?

Inflation is the rate of increase in prices for goods and services. Anything above a 0% inflation rate means that your money won’t buy as much today as it did yesterday. The difference depends on how much above 0% the current rate of inflation is.

Typically, the Bank of England (BoE) uses interest rates as its primary mechanism to control inflation. In times of high inflation, it will consider increasing interest rates to try to pacify the rise. Conversely, in times of low inflation, it will consider cutting interest rates.

Are interest rates going to rise, fall or stay the same?

In May this year, inflation rose faster than expected to a four-year high of 2.9%¹, up from January’s 1.8%². It fell back to 2.6% in June but is expected to rise again in the coming months to a peak of around 3% in October³.

Surely interest rates should be raised to combat this rise in inflation, right?

Not so fast! Arguably, some of the increase comes from the cost of the goods that we import which have, in part, risen because of the devaluation of sterling post the Brexit vote; something which is difficult for the BoE to control.

That aside, the pacifier that usually controls inflation is now largely blunt. Interest rates have been at their all-time low of 0.25% since August 2016. Before then, they had been at 0.5% since 2009!

At its most recent meeting, six of the eight members of the Monetary Policy Committee, including the Governor of the Bank of England Mark Carney, voted to keep interest rates unchanged. According to Mr Carney, now is “not yet the time” to start raising them. He has also said that if inflation continues to surge, higher interest rates will be “necessary”⁵.

What does this mean for your mortgage and savings?

If you owe money, the current low interest rates mean that your monthly payments are going to remain low. If inflation is high, the true value of your loan diminishes.

If you’re saving money in a bank account, the current low interest rates mean that your money is barely growing. If inflation is high, the value of your money diminishes and thereby its purchasing power.

How quickly does inflation reduce the value of your money?

To calculate the length of time it takes for inflation to halve your money’s purchasing power, you can apply the rule of 72.

For example, say you had £10,000 in the bank at an average inflation rate of 3% per annum. 72 divided by 3 equals 24. It means that your £10,000 purchasing power would be reduced to £5,000 in 24 years (assumes a 0% interest rate).

With many high street banks offering less than 1% to savers (the average is just 0.15%⁶), no clear sign of when interest rates will rise, and inflation not far off 3%, you could see the purchasing power of your money held on deposit fall much quicker than you may have anticipated.

Thankfully though, it’s not all doom and gloom. Two alternatives to bank savings accounts >

Does not knowing if or when interest rates will rise change any of your financial plans or decisions? Let us know by adding a comment below.

¹ The Guardian; ² The Guardian; ³ Bank of EnglandBank of England; ⁵ The Telegraph; ⁶ The Telegraph

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