Economic Latest – Inflation, interest rates, and what lies in store for 2014
With the new year firmly up and running, now is a good time to review those key drivers that could affect the economic landscape in the months ahead as well as consider how these might affect our savings and investment decisions. Paltry returns that struggle to maintain the spending power of our money has been the frustrating story of last year but is this set to change in 2014? We take a look at events so far this year in order to reveal what might lie in store.
Story so far
2014 has already brought us some surprises. Although the Bank of England (the Bank) base rate has remained unchanged, unemployment has been falling faster than expected and with the latest figures from the Office for National Statistics revealing inflation has fallen to its lowest level since November 2009, the year has so far asked more questions than it has answered. So what does all this mean?
Base rate on hold
The first meeting of the year for the Bank of England’s monetary policy committee resulted in no change to the base rate as they chose to hold it at 0.5% for another month. This means interest rates have been at a record low since March 2009, making this the 58th consecutive month in which rates have been at this level. 5 years now looks a certainty…
The decision was widely expected as the Bank of England’s governor Mark Carney has said the base rate will not rise until unemployment falls below a 7% threshold or there is an unexpected spike in inflation, the Bank’s so called ‘forward guidance’ strategy. Using the 7% threshold, it was previously thought rates would not rise until at least 2016 however according to the Office for National Statistics, the UK unemployment rate fell by a record 0.3% to 7.4% for the three months to October, representing the largest fall since jobless measurements began in 1971.
Where next for rates?
This question has increasingly been the centre of attention since Mark Carney’s introduction of the forward guidance strategy. The UK economic data continues to improve with Gross Domestic Product (GDP) expected to rise this year seeing an increase of up to 2.7%, taking the UK back to levels not seen since 2008, before the credit crunch.
With the unemployment rate now likely to approach the 7% threshold earlier than anticipated, the outlook for an increase to the base rate would appear optimistic however the Bank has made it clear that any such rise would be ‘a last line of defence’. The recent falls in unemployment rates has therefore prompted economists to predict an adjustment to the forward guidance policy by lowering the threshold to 6.5 per cent, possibly in next month’s inflation report. This would allow the Bank to hold interest rates at 0.5% for the rest of this year.
On the basis that interest rates on savings are closely aligned with the Bank of England’s base rate, this is a key consideration for those considering their options.
Inflation as measured by the Consumer Price Index (CPI) rose by 2% in the year to December 2013 which means the current level is now at the Bank of England’s target for the first time since 2009. The inflation rate, down from 2.1% in November, is now the lowest it has been since it stood at 1.9% in November 2009.
The largest contributions to the fall in the rate came from prices for food and non-alcoholic beverages and from recreational goods and services, offsetting an increase in the price of motor fuel prices. The Office for National Statistics said the rise in food and non-alcoholic drinks was the smallest since 2006.
Capital Economics’ UK economist Samuel Tombs expects the trend of lower inflation to continue over the next few months on the back of energy price reductions as utility companies pass on the government’s environmental tax cuts as well as last year’s falls in global agricultural commodity prices suggest that food price inflation could ease to close to zero soon. “CPI inflation looks likely to spend more time below the 2% target than above it in 2014” he commented (Capital Economics, 9th January 2014).
The real wage crisis
Far less commonly quoted than the Bank of England’s record low base rate and the ebb and flow of inflation is the fact 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 working population of the UK.
Whilst the fall in the annual rate of inflation to 2% is a welcome one, it still means that inflation continues to run well above pay growth with the latter rising at a rate of only 0.9%. With earnings failing to keep pace with inflation, 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 at an annual rate of 1.1%.
House purchaser’s no man’s land
Another factor that could have a dramatic impact this year is that house prices are currently rising by 5.4% a year, whereas wages are rising by considerably less. This means that the cost of buying the average home is going up six times as fast as earnings.
Furthermore, because the average house costs significantly more as a multiple of the average salary, the problem is being compounded. According to the Nationwide Building Society, the average property cost around £170,000 at the end of 2013 whilst the latest figures for average earnings in the UK from the Office for National Statistics show the figure at around £27,000. Even if you take out the impact of London on these figures, this is a serious situation for those looking to buy their first home or move to a larger property.
Although at first sight the reduction to the headline rate of inflation is good news, the wider economic landscape remains a major cause of concern for many in the UK and the outlook for 2014 is one which demands our close attention.
The consensus view appears to be that the base rate will continue at its record low of 0.5% for the rest of the year and inflation will remain broadly at its target level of 2%. With no change to the base rate, it is also unlikely that we will see a significant shift in the levels of savings rates on offer which could mean more and more of us losing money in real terms.
First time buyers hit the hardest
Perhaps those hit the hardest is anyone looking to save for a deposit since they are faced with a number of serious challenges. Not only are the savings rates on offer historically low thus making it harder to achieve capital growth in the shorter term, with salaries increasing at a far lower rate than inflation the actual amount available to save is also decreasing year on year.
This is further compounded by the significant rise in property prices over and above what we earn. So for those considering a house purchase or even simply trying to plan for this at some point in years to come, the situation is dire.
Effect on savers
With ‘much of the same’ being the outlook for savings rates, anyone with a fixed rate bond maturing is likely to face sizeable reductions in the level of return available from a product with a similar term.
With the Consumer Price Index currently running at 2%, basic rate tax payers need to achieve 2.5% from their savings to match inflation whilst higher rate tax payers need to achieve 3.3% just to stand still. Obviously higher returns are required to actually achieve capital growth, and that’s only if you reinvest the interest.
A review of the market shows that current savings rates are offering around 1.5% on instant access, 1.9% and 2.3% for one and two year fixed rates respectively, around 2.5% for a three year fixed rate and 3.2% if you fix for five years.
Therefore, although you continue to be rewarded with higher interest rates for tying up your money for longer, by using traditional fixed rate savings products tax payers need to commit to a minimum of 3 years just to break even and longer term to achieve any growth.
Even if inflation does spend more time below the 2% target this year than above it, not only is it the wider context of what is happening within the economy that should be taken into account, it is also what could happen beyond this year. Certainly these considerations should be a top priority for anyone looking to commit their capital for more than 12 months.
Failing to understand the real impact inflation can have on your capital can produce painful results, especially over time. Based on this current outlook, arguably there has never been a more important time to make sure your capital is working as hard as it can, but unfortunately the current market for savers leads to a tough decision – either lose money in real terms from a savings account, or take on more risk.
More than just food for thought
When committing to a fixed rate you are also assuming that inflation will not increase during the fixed term period, otherwise you would be worse off still. Even if you think that inflation could average at the Bank’s 2% target for the rest of this year, it only takes a small increase and suddenly you could be losing significant amounts in real terms.
Current savings rates lead anyone with half an eye on inflation down the longer term but whether now is the right time to tie up your money in a fixed rate bond for five years should be carefully thought through. The critical question remains that whatever timeframe you are considering for your savings, what will be the likely impact of inflation over that period? This should be more than just food for thought….
Inflation holds the key
The harsh reality of the UK economy since the credit crunch has resulted in an increased understanding of the impact inflation can have both on our standard of living and the returns from our capital. This can effect workers as much as those who are retired, and has pushed inflation into becoming a key deciding factor, especially when it comes to savers deciding where to put their hard earned cash.
Although disinflation has been the story of 2013 and the start of this year, there remains more than a little concern among economic and investment professionals that inflation could rear its ugly head at any time.
A ticking time bomb?
Ironically, real wage growth could indeed be the catalyst for a rise in inflation. Although many have not seen a pay rise for several years, people are being told that things are looking a bit better and corporate profits are at all-time highs. We have also seen consumer spending and consumer confidence picking up, so the next thing that should come is the anticipation of pay rises.
If the UK booms this year with wages rising and better than expected growth, bank lending and inflation will inevitably pick up and so looking towards 2015 and beyond, there is every possibility that inflation could surge – it simply does not seem realistic that it will continue to be at or around the target level of 2% if you have better growth and better employment.
Therefore, there is a danger that inflation won’t just pick up a little bit – it could be around target, around target, around target and then pick up really sharply. This could be the worst case scenario for savers and should be a key consideration for those reviewing their options, especially those looking to commit for more than 12 months.
A rising trend
Inflation may have come down based on the previous month, but this does not escape the fact that there is so much money held in savings accounts that is still being eroded by record low interest rates. With so many fixed rate bonds maturing and the equivalent product offering far lower rates, no longer can we rely on traditional fixed rates, whether in or outside of an ISA, to keep our savings on track.
This inevitably raises the question of taking on more risk to try and combat the effects of inflation and those who are especially reliant on this income are often having to consider moving up the risk spectrum with at least some of their capital.
Weigh up all of the options
High inflation, whether actual or anticipated, is one of the hardest challenges to face, especially during a period of record low interest rates. However, with every single instant access account paying far below the current rate of inflation, putting your money there in the hope of things changing could be a dangerous strategy.
Ultimately, which option or blend of options will depend entirely on your individual circumstances however, the impact of inflation, record low savings rates, the potential for interest rate rises and the ability for our income to increase in the 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.
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. Tax treatment of ISAs depends on your individual circumstances and may be subject to change in the future.
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.