What might the rise in inflation mean for your money?

After reaching 2.1% in May, inflation jumped up to 2.5% in June, according to the Office for National Statistics (ONS).

Analysts are pointing to more expensive food, clothing, footwear, and fuel, as inflation continues to make the cost of living more expensive.

A rise in inflation can have a marked and notable impact on your entire financial situation, from your savings to your investments and pensions.

Here’s what a rise in inflation can mean for you, and how you can mitigate it.

Inflation is a rise in the cost of living

In essence, inflation means products and services become more expensive over time.

For example, imagine something you could have bought for £100 last year, such as a microwave. If inflation increased by 2.5% for the year, that same microwave would cost you £102.50 just 12 months later.

That’s because inflation slowly increases the cost of products and services.

The Bank of England targets just 2% inflation each year

Each year, the Bank of England (BoE), the UK’s central bank, targets inflation of 2% growth each year. This helps to keep the economy moving, stimulating growth.

To try and manage the rate of inflation, the BoE can make changes to its base rate. This is the bank’s internal interest rate, set by an internal panel called the Monetary Policy Committee (MPC).

Commercial banks and building societies can hold money with the BoE, receiving interest at the amount of the base rate. In turn, this determines the interest that they offer on their own accounts and products.

When the economy is stalling and the rate of inflation is too low, the MPC can recommend a cut to the base rate. This means banks and building societies receive little interest on their savings, as do their customers.

As a result, it encourages these financial institutions to lend and spend their money, as there’s little incentive to save. This movement of money stimulates the economy, with the BoE hoping that it will raise inflation.

The BoE took this course of action in March 2020 in response to the Covid pandemic, first reducing the base rate from 0.75% to 0.25%, and then to an all-time low of 0.1%. With concern that lockdowns and the spread of the virus would damage the economy, this was a pre-emptive measure to encourage spending.

However, when inflation exceeds the BoE’s 2% target, the MPC can raise the base rate. This incentivises financial institutions to stop spending and start saving, as they can receive more money in interest.

This also encourages individuals to save, as banks and building societies usually pass these interest rates on their customers.

With or without a change to the base rate, inflation can still have a notable impact on your finances.

Your savings could lose value against inflation

With interest rates currently so low, it’s possible that your savings will lose value against the rate of inflation, before the base rate even rises.

According to Moneyfacts, the best easy-access savings interest rate as of 15 July 2021 pays interest of just 0.5%. That means, for each £100 you save, you would have £100.50 in a year’s time.

However, if inflation drives the cost of living up to 2.5%, something that you could have bought for your £100 a year ago now costs £102.50. That means your savings, which have risen to just £100.50, aren’t keeping up with the inflating cost of goods and services.

As a result, your savings lose value in real terms against inflation, as it literally has less spending power.

Of course, a rise in the base rate could be a good thing for your savings. It could see the interest rates on your accounts go up, bringing your money closer to competing with inflation.

Investments and pensions typically outperform inflation

One way to avoid your savings losing value is to invest your money instead.

Pensions and investments have historically been the best way to avoid the eroding effect that inflation can have on your savings.

Depending on your portfolio, your targets, and your tolerance for risk, you can invest your pension and investments in such a way that means the returns they make beat inflation.

For example, according to trading platform IG, investments in the FTSE 100 achieved average annualised returns of 7.8% each year from 1984 to 2019. If your portfolio achieved those returns, your money would comfortably outcompete inflation.

(Source: https://www.ig.com/uk/trading-strategies/what-are-the-average-returns-of-the-ftse-100–200529)

If you need help designing a portfolio that achieves the returns you need, you should consider working with a financial planner.

Your mortgage payments could rise with the base rate

Another way inflation might impact you is that your monthly mortgage repayments could rise, as a rise in the BoE’s base rate could see your mortgage interest rate rise too.

Of course, this entirely depends on the kind of mortgage deal you have.

If you have a fixed-rate mortgage, you won’t be affected. This is because the interest rate you agreed with your lender is fixed until the end of the deal.

But, if you have a variable- or tracker-rate mortgage deal, you could see your repayments rise.

Variable-rate mortgage deals set their interest rate using the lender’s own internal standard variable rate (SVR). A lender can change this rate at any time they like, and a rise in the base rate is a common time for them to do exactly that.

Meanwhile, tracker-rate mortgages directly use the base rate to determine their interest rates. So, a rise in the base rate means a rise in your mortgage interest rate.

Therefore, a rise in the SVR or on your tracker-rate deal would mean more interest added to the total you owe, bringing your monthly repayments up.

You could avoid this by finding a fixed-rate deal that keeps your monthly repayments consistent for a set period.

Speak to us

If you’d like to find out more about how inflation might impact your finances, please contact us at Britannic Place.

Email info@britannicplace.co.uk or call 01905 419890 to speak to us.

Please note

A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

Your home may be repossessed if you do not keep up repayments on a mortgage or other loans secured on it.