Inflation, interest rates and you

The UK inflation rate soared in August, rising from 2.0% the month before to 3.2%. The largest leap since records began back in 1997 has been driven by higher food costs according to the ONS.

Understanding inflation and interest rates is one of the most useful things you can do to improve your wealth.

In this article, we explain:

• Why understanding these terms can impact your finances
• What the effect of inflation is on interest rates 
• How compound inflation can make a big difference to your money
• The difference between nominal and real interest rates

UK inflation has exceeded economists’ targets and currently sits at 3.2%. The fear now is that we risk falling into “stagflation”, meaning the economy is not growing, unemployment is rising and wages are static. At the same time the prices for goods and services we all need are still rising.

What is the effect of inflation on interest rates?

In theory, inflation and interest rates are in an “inverse” relationship. When rates are low, inflation tends to rise – and when rates are high, inflation tends to fall.

However, this does not always happen in practice.

What is the ‘inflation shopping basket’?

When economists at the Office for National Statistics (ONS) calculate the rate of UK inflation, they look at how the price of products have risen or fallen since the previous year.

To do this, they pick around 180,000 products and services based on what people typically buy. The overall price for this “basket” of goods is plugged into the consumer prices index (CPI), which is the most widely used measure of inflation.

• In the year to August 2021, the CPI inflation rate was 3.2%.

The virtual basket is reviewed every year because people’s tastes and spending habits change over time.

• 1940s: condensed milk, corned beef and ladies’ corsets
• 2021: hand sanitiser, smart watches and home weights

The retail price index (RPI) is another inflation measure used. Like the CPI, it draws on a basket of goods and services but adds mortgage interest payments.

• In the year to August 2021, the RPI inflation rate was 3.8%.

What is the ‘Bank rate’?

Bank rate is the interest rate set by the Bank of England. It currently stands at a record low of 0.1%.

The rate affects all sorts of aspects of the UK economy. It determines how expensive mortgages and loans are, to how much savers get paid for their bank deposits.

It is sometimes called the Bank of England base rate, and it is set by the central bank’s nine-member Monetary Policy Committee.

Find out more: When will interest rates rise?

What is the Fisher effect?

The Fisher Effect is an economic theory that describes how inflation relates to both real and nominal interest rates.

Nominal rates describe how much a saver gets when they deposit money in a bank.

If you put £3,000 in my savings account, and the bank offers a 3% interest rate, then each year you will get £90 extra.

However, that £90 isn’t quite what it seems.

If, at the same time, the inflation rate is 2.5%, then the cash in your savings account is only really growing at 0.5% a year (3% minus 2.5%) and the interest you earn will be just £15.

In other words, the purchasing power of your cash has been eroded.

The key thing to remember is that there is a difference between real and nominal interest rates, and inflation has an impact on the relationship between the two.

What are ‘Keynesian’ and ‘monetarist’ theories?

Keynesian theories are those named after the economist John Maynard Keynes (1883-1946). His work has been hugely influential in British and world economics.

In the midst of the Great Depression of the 1930s, Keynes was highly critical of the British government’s pursuit of austerity: cutting budgets and drastically reducing spending. He said that budget deficits during recessions were actually a good thing, because they help enhance demand.

Keynesians argue that when governments borrow and spend more on, say, infrastructure, this improves business confidence. In turn, companies are willing to borrow more and to hire more staff, so the economy grows.

That’s the theory, anyway.

Monetarism is the other dominant economic model of the 20th and 21st centuries.

Monetarists believe that the overall amount of money in an economy determines the rate of inflation. If governments print too much, inflation will rise, they say.

Most advanced economies, including the UK, the US and Japan, have printed unprecedented amounts of money in response to the coronavirus pandemic.

Critics suggest this approach has inflated the prices of everything from cars, to food, to stocks and shares, and is causing a damaging upwards spiral in inflation.

How will inflation affect my pension?

Unfortunately, higher rates of inflation reduce the purchasing power of our cash and the value of pensions.

If, say, your pension grows by 5% this year, but inflation is at 2.5%, then your pension will only really increase in value by 2.5%. You might see this written as an increase in “real terms”.

It is also worth considering “compounding inflation”. Just as with the effect of “compound interest” on savings or investments, inflation will slowly erode the rate of growth in your savings or investments.

Instead of occurring in a vacuum, where prices are reset to zero each year, inflation compounds over time. And so its impact can be significant on long-term savings like pensions.

This is why some asset managers and pension providers measure the “inflation-adjusted returns” on particular investments.

One other key element of how inflation affects pensions is the “triple lock”. Introduced in 2010, this policy means the state pension rises each year by the highest of the three factors below:

• 2.5%
• Inflation as calculated by the CPI
• Average wage growth

As a result of the pandemic artificially inflating wages to 8.8% due to millions coming off furlough and onto payroll, the government decided to temporarily suspend the triple lock. In April 2022, the wage growth element will be removed.

Find out more: What is the triple lock on state pensions?

How can I future-proof my finances from inflation?

When inflation is rising and people want investments that are better placed to maintain or increase their value, they often turn to “safe havens”.

These tend to be rare or unique items such as classic cars or works of art, or commodities such as gold and silver. These are all assets whose prices are underpinned to some extent because supply is limited, at least over time.

Other “safe havens” assets that are expected to remain popular for decades to come include real estate.

Splitting investments across a range of different industries, and asset types, is one way to protect against price inflation.

This article first published by The Times on 15 September 2021