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Inflation threat prompts interest rates speculation Go compare with our comparison table

Inflation threat prompts interest rates speculation

25 January 2011 / by Paul Dicken

With persistently high inflation, we look at the prospects for interest rate increases and using ISAs to prevent tax from further eroding the return on your savings.

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The Bank of England is coming under pressure to act on the above target level of inflation, with more predictions that rates could be raised in coming months.

Inflation went up to 3.7 per cent in December 2010, a rise from the previous month’s 3.3 per cent rate. The Office for National Statistics said the main drivers for the rise were increases in air transport costs, petrol and diesel prices, gas energy bills and the largest ever rise in food prices between November and December.

These factors affecting the Consumer Prices Index (CPI) measure of inflation are largely seen by the Bank of England as temporary shocks pushing up the overall CPI rate, while the fundamentals of the economy are not driving up inflation.

For example, in the Bank’s Inflation Report at the end of 2010, it said: “Inflation is likely to stay above the 2% target throughout 2011, given the forthcoming rise in VAT and continuing increases in import prices. As the impact of those factors on inflation diminishes, inflation is likely to fall back, reflecting continuing downward pressure from the persistent margin of spare capacity.”

Danger of rate changes

While savers are suffering from low interest rates against a backdrop of rising prices, analysis of the figures compiled by Age UK Enterprises showed costs for older people have been higher. Using the alternative Retail Prices Index (RPI) measure of inflation, the organisation said over 55s were on average £600 a year worse off.

However, while costs are rising, low rates help boost a slow economy, partly by keeping borrowing costs down. There are some who predict that an incremental rise in rates could mean businesses find their debt unmanageable and have to fold. Interest rate rises will also impact on mortgage holders.

Director of UK strategy at F&C Investments Ted Scott said: “Ultimately, the Bank is right to be cautious in raising rates because of the fragility of the economy at a time when the effects of the austerity measures are going to be felt the most.”

Scott did urge the Bank to communicate its policy more effectively to help restrain people’s expectations on inflation.

Writing in the Telegraph on 24 January, managing director of Capital Economics Roger Bootle said if the Bank believed its analysis of inflation was right, it should ignore calls for rate increases.

“If it raised rates now it would seem to be admitting it had been wrong about inflationary prospects...The result would be that in both markets and the real economy people would assume that this was the beginning of a huge turn in the interest rate cycle.”

Prospects for savers

Although finding savings that can offer inflation-combating rates of return has become increasingly hard, it is probably worth remembering that inflation hit 20 per cent in 1980, and was over nine per cent in 1990.

Whether the Bank of England will raise rates is difficult to predict, largely because it depends on a number of factors, not least what will happen in terms of economic growth in coming months. News on 25 January that the UK economy shrank by 0.5 per cent in the final quarter of 2010, underlines the fragile nature of the recovery.

However, predictions of rate raises were generally leaning towards a longer time frame but the pressure is building on the Bank to bring forward a rate increase.

Fair Investment Company savings and investment analyst, Julie Smith, said: “With the official rate of inflation at 3.7 per cent in December 2010, basic rate taxpayers need an annual return of 4.63 per cent on savings, before tax, to stop the value of their money being eroded. For a higher rate tax payer the savings rate needs to be 6.17 per cent.

“With the current savings rates this feat is almost unachievable, but a good way to prevent tax from eating away at any return you are getting is to take full advantage of your ISA allowance. Make sure you are reviewing the interest rate on your savings and consider consolidating ISA accounts, but make sure to transfer existing ISAs so they retain their tax-exempt status, rather than cashing them.”

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