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Interest rates, inflation and recession - what it means for you

Interest rates, inflation and recession - what it means for you

01 May 2012 / by Oliver Roylance-Smith

It seems the current economic environment produces more losers than winners and continues to cause both savers and investors a number of concerns. We take a look at the main drivers of this difficult landscape and what it might mean for you.

Low interest rates continue

Let’s start by asking a simple question - when was the last time you heard some good news on the financial front that made you feel things were looking up? A bit of a difficult one I fear and the last few weeks have certainly not helped to inspire our confidence.

During April the Bank of England voted once again to hold interest rates at 0.5%, resulting in this record low continuing well into its third year. The vote was unanimous, although there have been continued rumblings surrounding when an increase may actually happen, as well as a split in the voting on the increased use of quantitative easing.

This uncertainty is particularly unhelpful since it deflects attention from the crux of the matter, which is the effect this has on savers when deciding what to do. What is happening behind the scenes is that not only have fixed rates been under pressure, in recent weeks they have been falling, thereby increasing the need to be even more thorough when considering your options.

Inflation not helping

Two weeks ago the headline rate of inflation as measured by the Consumer Prices Index rose to 3.5%, way above the Bank of England’s target level of 2%, or ‘uncomfortably above target’ as deputy governor Paul Tucker put it. More worrying were the comments of former Monetary Policy Committee member Andrew Sentance who pointed to a number of reasons why high inflation may persist.

These include strong growth in India and China putting upward pressure on food and energy prices, the big fall in sterling which pushed prices up further, spare capacity in the UK economy provided by quantitative easing not applying the downward pressure the MPC had hoped for, and rising prices encouraging businesses and the public to expect higher inflation in the future.

The latest minutes from the meeting also state that inflation is likely to exceed projections, which would seem to fit in with National Savings & Investments's recent announcement that it “does not expect” to reintroduce its Index-Linked Savings Certificates any time this year.

Recession here again

Last week the economy shrank 0.2% in the first quarter of 2012. This followed a 0.3% decline for the final three months of 2011 and since consecutive quarters of negative GDP meets the technical definition, the UK has officially fallen back into recession – the dreaded double dip as we feared back in November.

Regardless of the definition, the fact remains that none of the measures taken thus far are achieving the desired results, which only adds to the general feeling of dampened spirits and lack of progress, with no one more badly affected than the saver looking for a decent return.

Nowhere to hide

With the returns on fixed rate bonds falling, high inflation looking far more likely to continue along with the UK in recession, you would be forgiven for thinking that there is nowhere to hide. The landscape certainly does not create an environment that makes deciding what to do a straightforward process.

The combined effect of these factors suggests that interest rates could rise but so too could inflation and we are unlikely to see one without the other. However, the interaction of how and when this will play out and, more importantly, the effect this will have on savings rates remains uncertain.

Keep your chin up

What does appear certain is that there is no quick fix for the UK economy and whilst we await signs of continued recovery, the harsh reality is that this is undeniably a long way off. Yet decisions as to what to do with our savings cannot and should not wait; the effects of receiving returns lower than inflation for a continued period of time, for example, should never be underestimated.

Facing the savings dilemma head on and keeping your chin up amidst a very challenging economic environment is the only way forward, and making sure you understand all of the options available is an absolute must...

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