Inflation Falls to Record Low – Good News or Bad?
Inflation hits 15 year record low
The rate of inflation as measured by the Consumer Price Index fell to 0.5% in the year to December 2014, according to official figures from the Office for National Statistics announced last week. This represents a fall of 0.5% on the previous month and is the joint lowest level on record. The last time inflation fell by 0.5% in a single month was May 2000.
The key contributors to this significant fall in the Index are the plummeting price of oil,. which meant that the cost of motor fuels fell by 10.5%, as well as stagnant gas and electricity prices compared with energy price increase a year earlier. Food prices also dropped by 1.9%.
Deflation on the cards?
The effect of lower oil prices, plus the ongoing price war between the high street supermarkets, and it is likely that inflation will remain below 1% for some months, although some see further falls as a possibility. Capital Economics UK economist, Paul Hollingsworth, said he felt inflation still had further to fall as there was still some way to go before the reduction in the oil price was fully accounted for in the headline rate.*
Commenting on the recent fall, he stated “the further 20% or so fall in oil prices since December’s average level looks set to push CPI inflation to a record low of around 0.2% over the next couple of months… and given uncertainties surrounding how quickly and to what extent lower oil prices will cause price rises for other goods to moderate, a brief period of deflation is not entirely out of the question.”
Impact on interest rates
Given the absence of inflationary pressures, it is difficult to see why the Bank of England would even consider higher interest rates and yet although these latest figures point to a strengthening of the position to defer raising interest rates, the overall impact on future Bank policy is unlikely to be shifted.
Mr Hollingsworth suggested that the impact on an interest rate rise is likely to be minimal and with the Bank of England’s Monetary Policy Committee focused on the medium term outlook for inflation, concluded that “its present weakness is likely to only act as a speed limit rather than an outright roadblock to raising interest rates.”
Impact on households
In fact, there seems to be greater consensus among economists that the looming general election will have far more of an impact on future rate rises with nothing happening before then.
And since the outlook for interest rates therefore is to remain at its current low throughout the year, the impact for households may be good news.
Providing low inflation is maintained and the UK economy does not slip into deflation, the dramatic drop in the price of oil – which was more than double the current level a year ago – coupled with frozen, and in some cases reduced utility prices, may well see 2015 offering a small but nevertheless valuable respite for households as they may start to benefit from improving earnings growth and a lower cost of living.
Mixed news for savers
A reduction to the headline rate of inflation is always welcome news for savers as the value of the money they hold in their accounts is not being eroded so quickly. However, the picture is not all rosy.
Even at this historic low, there still remains a significant number of savings accounts that are not paying enough interest to beat inflation, and that’s before tax is taken into account. Despite this reduction generally being considered a temporary blip which will not significantly impact on the Bank’s monetary policy, there are few who would bet on an increase to interest rates before 2016 and with many savings rates continuing to be cut, this is a genuine cause for concern and in many cases a strong reason to review our current situation.
Where to start?
Taking the time to check the interest being paid on all of your savings accounts is an obvious and yet important place to start. Even with inflation and interest rates at record lows, basic rate tax payers still need to earn 0.625% to match inflation whilst higher rate tax payers need 0.83%.
Fortunately, at present these returns are more than achievable from a half decent instant access account although it is also worth considering some of the higher interest rates available from certain current accounts in the market, albeit the headline rate is normally only paid up to or within a certain balance limit and many have additional terms and conditions.
To fix or not to fix?
Also to consider is the fact that many fixed rates are currently offering far less than the similar length duration fixed rate bond of yesteryear, meaning that simply rolling into the current top deal over the same term can result in a significant reduction in the overall return from your savings. For those who are prepared to forgo Financial Services Compensation Scheme protection, then higher rates still are available from peer to peer lending however be sure to understand exactly where your money goes and where the real risk to interest and capital lies.
Should you ultimately decide to commit to a fixed rate, then before applying make sure you are confident that rises to the cost of living will not increase significantly during the fixed term period, otherwise those inflation beating returns may well come under pressure.
Although longer term fixed rates traditionally offer the higher returns, it is perhaps timely to remember that a little over three years ago you could get around 3.15% on instant access, whilst now you are unable to secure this level of return even if you are prepared to tie your money up for 5 years. So whether now is the right time to tie up your money in a fixed rate bond for five years should be carefully considered.
Structured deposits offer an alternative to fixed rate bonds by sacrificing a fixed rate of return with the potential to achieve higher returns, usually dependent on the performance of an underlying investment such as the FTSE 100 Index. These also normally have a fixed term although some do have the ability to mature early, from as early as the end of year two onwards. Since these returns are not guaranteed, you may though only end up with a return of your capital.
Weigh up all of the options
Speculation around interest rates will no doubt continue but for both savers and investors, the key consideration should be what impact this might have on the return we receive compared to the needs from our capital. We should ask ourselves exactly what we are buying before committing to a product and consider what alternatives are available, especially in light of the New ISA rules give us greater freedom and increased investment limits.
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.
* Wealth manager, 19/01/2015
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