If it isn’t bad enough that the latest inflation figures have jumped to 2.7%, what’s making matters worse is that earnings are not increasing by anywhere near enough to keep pace. Combined with record low savings rates and the future certainly does not look bright. We take a deeper look at the impact this is having on both saver and investors.
Savings rates versus inflation
In our previous article we commented on how despite inflation falling to 2.4% for the 12 months to April 2013, a basic rate taxpayer still needed to earn 3% and a higher rate tax payer 4% just to keep their savings standing still, let alone grow in real terms.
With the dire state of traditional savings products currently on offer this is no easy feat, even if you are prepared to tie your money up for the longer term. It seems that the bank’s lack of appetite for our money is indeed set to continue.
A fragile affair
The other concern was that even if you could secure a decent return on your savings, inflation only had to creep up a little and suddenly you would find yourself locked in to an interest rate that was losing you money in real terms.
With so few rates hitting the mark and with so many savers already feeling the impact of having their capital eroded, the reality of this happening is all too clear. Combined with the real possibility of top paying interest rates falling further and this becomes of even more concern – a situation which certainly demands our closest attention.
Temporary blip or under control?
But would this be a temporary blip, or more of the start of a longer term trend of inflation coming under control? Based on the fact the Bank of England has consistently failed to keep inflation under control and admitting that it could well remain above target for another two years, the bottom line for hard-pressed British families and pensioners is that inflation is not under control, but rather will find it ever harder to pay for the essentials of life.
Our conclusion then was that this would indeed be a temporary blip and it would therefore be no shock at all if the cost of living were to rise again the following month – which is exactly what has happened...
Inflation up... and rising?
The consumer price index grew by 2.7% over the year to May 2013, up from 2.4% in April. This means that for the 42nd month in a row, UK inflation has exceeded its 2% target with the rate now having returned to the levels seen between October 2012 and March 2013.
Unfortunately it looks like it is also back on the rise with a number of economists predicting further increases in the coming months. Capital Economics chief UK economist Vicky Redwood says: “May’s rise in UK inflation confirms that April’s drop was just a blip” and that “inflation will probably get above 3 per cent in the next month or two…”
Bank of England fails to build confidence
Although Miss Redwood goes on to state that the peak is hopefully not too far away now and it will get to its target around the start of next year, I am not so confident. The stickiness of inflation has been compounded by the Bank of England’s reluctance, even inability, to respond through monetary policy, for fear of worsening the already depressed level of growth in the UK.
Further, it would seem this is a situation that the Monetary Policy Committee expects to continue according to comments made by committee member Ian McCafferty: “Inflation in this country has been persistently above the 2% target for the past three years, and over 3% for roughly two-thirds of that time – peaking at 5.2% in September 2011. And we expect that on balance it will remain above the 2% target until at least the end of next year.”
Another day, another forecast
During periods of deleveraging such as the one we are experiencing right now, inflation is also much more likely to surprise, both savers and investors should be very wary indeed. Whilst the Bank of England has told us time and time again that inflation will be back at 2% in two years time, it doesn’t take much to lose faith.
For example if we go back two years to the May 2011 Bank of England Inflation Report we are supposed to be having a rather pleasant combination on economic growth of 3% per annum and inflation just below the 2% target. As any saver, worker, pensioner, indeed all of us will know, the reality has been a much more toxic mix of above target inflation combined with low or no growth. Add into the mix record low savings rates and the situation really is getting as serious as it’s ever been.
Feeling the effects
If inflation is allowed to persist even at what might seem low rates it has considerable effects via the power of compounding. Those who are economically weakest are those who are usually affected the most and anyone relying on savings income fall firmly into this camp – they will certainly be experiencing falls in income.
Another major effect on the UK economy of above target inflation has come from its impact on real wages. Put simply, if earnings increase at a lower rate than inflation, the amount you have at the end of each month is reducing (all else being equal such as tax, etc).
Adding to the woes – real wages fail to keep up
What is perhaps less common knowledge than the consistently above target inflation is that annual inflation has risen above wage growth every month since November 2009, creating a continuous downwards push that has been felt by every inch of the UK economy.
Importantly inflation continues to run well above pay growth, which was just 0.9% per year in the three months to April 2013 or 1.3% if bonuses are included, up only marginally on the 0.8% record low seen in March this year.
With the latest inflation move back up to 2.7%, the squeeze on consumer purchasing power remains appreciable given that inflation is running at essentially double underlying annual average earnings growth. In other words, real wages are falling by at least 1.4% per annum (source, ONS Average Weekly Earnings, April 2013).
The compound effect
The latest inflation numbers remind us that the ongoing erosion of spending power from rising prices will continue to act as a brake on economic recovery via its impact on the level of real wages increase and when compared to low and indeed falling savings rates.
Needless to say the compound effect of this over time is significant as not only is what we are putting away being eroded by inflation, the amount we have to put away is also diminishing highlighting the compounding impact that a low rise in earnings is having on savers trying to build up that nest egg.
What to do?
When considering savings options some difficult decision may have to be made. On the basis that any money kept in instant access accounts is likely to lose money in real terms both now and for the foreseeable future, being clear on exactly how much you might need and when is a key consideration.
The next consideration is what to do with any excess savings which is where the term of the product becomes a key factor. With medium to long term fixed rates currently unable to offer inflation beating returns, should you commit to one of these the value of your capital will be eroded at current inflation levels, and that’s only if you don’t use the interest you receive. Should inflation rise, then the impact of this will be even greater over time.
As an alternative option to fixed rate bonds you could consider a structured deposit. Interest in these has continued to rise in the current economic environment since they combine full capital protection with the opportunity to achieve higher returns than would be available from a fixed rate bond of similar duration – therefore offering the potential to beat inflation but without putting your capital at risk.
Structured deposits are essentially a combination of a deposit and an investment product where the return is dependent on the future performance of an underlying asset, commonly the FTSE 100 Index or a number of shares listed within the FTSE 100. By linking your return to the stock market and thereby sacrificing a fixed rate of interest, you create the opportunity to receive higher returns. The downside is that if the index does not perform in the way required to produce the stated returns, you will only receive a return of your capital (unless there is a minimum return built in).
Weighing up all of the options
Since there is the potential to achieve only a return of initial capital, structured deposits are not designed to meet the needs of every saver or to receive your entire savings. Ultimately, which option or blend of options will depend entirely on your individual circumstances.
These are unusual and challenging times and traditional savings accounts are currently falling short of meeting the pressures put on saver’s capital by the continuing economic situation. Above target inflation, record low savings rates, low wage increases and an uncertain future are all relevant factors when deciding what to do. As a minimum we should make sure that all of the options available are weighed up very carefully indeed.
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No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular plan. If you are at all unsure of the suitability of a particular product, both in respect of its objectives and its risk profile, you should seek independent financial advice.
Some of the plans referred to in this article are structured deposit plans that are capital protected. There is a risk that the company backing the plan or any company associated with the plan may be unable to repay your initial investment and any returns stated. In this event you may be entitled to compensation from the Financial Services Compensation Scheme (FSCS), depending on your individual circumstances. In addition, you may not get back the full amount of your initial investment if the plan is not held for the full term. The past performance of the FTSE 100 Index and any of it shares is not a guide to its future performance.
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