Interest rate latest and what this means for savers
Although the drop in the headline rate of inflation by 0.5% is good news for savers, the interaction between inflation and interest rates when considering the outlook for savings rates still remains far from clear. Whether interest rates will rise and if so when seems to be the main focus for economists and yet the underlying impact on savers either way seems to be worryingly ignored. We take a look at the latest economic data in order to find out what all this might mean for savers.
Latest inflation figures
The headline rate of UK inflation, as measured by the Consumer Price Index (CPI), has fallen to 2.2% for the year to October 2013, according to the latest figures from the Office of National Statistics. The fall came as a surprise to many economists who were expecting a smaller reduction to around 2.5%. This sizeable fall of 0.5% on the previous month also means that CPI inflation is now at its lowest level since September 2012.
The government statistics body figures show transport, most notably motor fuels, and tuition fees were the main drivers of the fall in CPI with no notable upward contribution recorded over the month.
Reduction in context
Inflation in recent months has been lower than the Bank of England expected in its August Quarterly Inflation Report. However, although this is of course a welcome decrease, it should not be forgotten that it is still above the Bank of England’s official inflation target of 2%, and has been since December 2009.
Another key comparison is inflation versus wages and the latest annual inflation rate worryingly remains well above average wage increases. Total pay remained sluggish, with a 0.7% rise on the previous quarter and regular pay growth (i.e. earning excluding bonuses) was only marginally stronger, up just 0.8%, the weakest figure since comparable records began in 2001.
This is a significant difference and means that those who are solely reliant on their earnings are at least 1.4% worse off each year as the purchasing power of their net earnings continues to be eroded.
Short term view
In response to the latest figures, Capital Economics UK economist Martin Beck stated: “Looking forward, inflation may tick up a touch in November as some of the recent announcements of hefty increases in energy prices start to take effect. But if rumours of Government action to reduce energy prices in December’s Autumn Statement are correct, this upward pressure could be short-lived.”
However, regardless of the outcome of the government’s energy measures – as yet unspecified – the short term forecast for inflation would prudently consist of fluctuations around the current level over the winter before embarking on an upward trend next Spring. Certainly a level beyond 3% looks likely later on in 2014 once the reality over petrol prices and household energy bills starts to properly filter through.
Bank of England eyes earlier interest rate rises
So what does this mean for interest rates? Under Mark Carney’s forward guidance plans unveiled in August, the governor of the Bank of England said that interest rates should not rise until unemployment falls below 7% unless inflation was consistently above 2.5%.
In the Bank’s latest quarterly inflation report published earlier this month, Carney says there is a 40% chance the threshold could be reached next year, a 60% chance by 2015 and a two-thirds chance by the end of 2016.
Taking a backwards step
This is a significant shift from August forecasts when the Bank gave a 25% chance of meeting the threshold by the end of next year. The Bank had previously forecast a 40% chance of unemployment falling below 7% by the end of 2015, rising to a 50% chance in early 2016.
Unemployment at a three year low
Office for National Statistics data published on the same day showed the unemployment rate fell slightly to 7.6% in the three months to September. The 0.2% drop on the previous quarter puts the number of unemployed at 2.47 million people. The 48,000 fall in the number of unemployed has pushed the rate down to its lowest level in more than three years.
IHS Global Insight chief UK and European economist Howard Archer believes the unemployment rate will continue its downward slide, reaching 7.2% by the end of 2014. He thinks the rate will hit the yardstick for Bank of England monetary policy of 7% in the second quarter of 2015.
However, revealingly Mr Carney defended his forward guidance policy and said he will consider other factors to rise rates and not just employment figures. He said: “The unemployment threshold is a staging post for assessing policy and not a trigger for automatic increases in interest rates. When the threshold is reached the monetary policy committee will set the policy for inflation against the need to provide support for the recovery.”
So what are we to think?
Most people agree global monetary policies are set to cause inflation at some point, but it’s the timing and extent that is unknown. Based on the latest figures from the Bank of England, an unexpectedly strong recovery has introduced a risk that the Bank might need to raise rates in just a year’s time, towards the end of 2014.
The Bank has made it clear that there will be no such automatic trigger regarding interest rate rises, suggesting that monetary policy is on hold for the foreseeable future and the main message therefore is not to put too much emphasis on the 7% unemployment rate. The reality is that inflation is far more likely to be the main driver of change so provided inflation pressures stay subdued, interest rates are going nowhere for a long time yet, even if economic growth really picks up.
Although all committee members agreed that none of the price stability ‘knockouts’ that would override forward guidance had been breached, the minutes go on to say there are “uncertainties” over the durability of the UK’s economic recovery, as well as risks over wage and price-setting. This means growth and inflation are “highly unlikely” to follow the Bank’s projections exactly.
Worst case scenario
The final point to consider is that even if interest rates do go up, will this in itself affect savings rates for the good? The answer has to be either ‘no’ or ‘not immediately’. If interest rates have risen it is likely that inflation will have been the overriding decisive factor rather than unemployment or growth rates.
On the basis that economic growth looks relatively anaemic for the foreseeable future, there could easily be an environment where growth is positive but slow, inflation is higher than its 2% target, potentially by some margin and interest rates have gone up. But there is no obvious link to whether there can be expectation that savings rates will follow suit – this could therefore create a real worst case scenario.
Future savings rates forecast
Interest rates have fallen dramatically since the Government’s Funding for Lending Scheme came into effect in August 2012. This gives banks and building societies a cheap source of finance so they are not so reliant on savers to lend them money. Since then, banks and building societies have delivered a series of cuts to new savers and often, once they find themselves at the top of the best buy tables, they lower their rates to new savers as well.
In April of this year the Bank of England extended this scheme for a further year — until January 2015. Interest rates are not therefore expected to rise anytime soon so there would seem to be no respite from these record low rates in the foreseeable future, regardless of what the economic environment throws us. This is not a bright horizon.
While the Bank of England base rate has remained unchanged at 0.5%, interest rates on best buys have crashed down to shockingly low levels following the government’s launch of the funding for lending scheme. The current raft of savings rates therefore continues to create a challenging time for savers.
Fixed rate bonds, the traditional mainstay for many savers’ portfolios, are at record lows. Leading one year fixed rate bonds currently offer around 1.9%, two year fixed rates around 2.3%, three year fixed rates around 2.6% and 3.1% if you can fix for five years. This means that many maturing bond holders are looking at falls in income of up to halve when considering reinvesting in the same length bond again.
Savers in trouble
The result is that many have moved away from longer term fixed rates in favour of instant access or short term notice accounts on the basis that something will happen relatively soon which will then spur them on to take further action. Although understandable, the above highlights this could be a very dangerous strategy indeed.
In addition, looking at the interest rates available from instant access accounts, two years ago you could secure 3.15% whilst leading rates are currently almost half at around 1.6%. With inflation at 2.2%, even if you don’t pay tax you are still losing a significant amount of purchasing power as each month ticks by.
Action to take?
The most important action to take is to understand the impact inflation is having on your savings and the value that could continue to be eroded from your capital if you stand still.
If inflation continues at its current level of 2.2%, a basic rate tax payer needs to achieve 2.75% and a higher rate taxpayer 3.66% just to keep pace. Perhaps the risk warning that should be made by every provider before a customer buys a fixed rate bond is to make it quite clear that they will lose money in real terms unless inflation falls sharply and remains at a much lower level.
If you have not yet done so, ask yourself the likelihood of this happening, especially if you have a sizeable amount of your savings in instant access? The impact of inflation, especially over time, is something which not enough savers put sufficiently high on their priority list prior to taking action.
Therefore, 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. With medium to long term fixed rates also currently struggling to offer taxpayers inflation beating returns, should you commit to one of these the value of your capital could also be eroded at current inflation levels. Should inflation rise, then the impact of this will be even greater over time.
We must be prepared for what might happen and not be frustrated by finding ourselves tied into something which ends up providing us with a negative return after tax and inflation, purely because we ignored those crucial factors which can affect our overall return.
There are a number of alternatives available to traditional fixed rate savings plans. Since the returns are not always guaranteed, these are not for everyone and are unlikely to be the home for your entire savings pot. However, they do offer the potential for higher returns and with the current outlook for savers looking set to throw even more challenges could be a worthwhile and timely consideration. Like fixed rate bonds, your initial capital is protected and is eligible for FSCS compensation up to the normal savings limits.
Diversifying savings portfolios to include a wider range of options could offer a more stable way to provide the level of returns savers need over the longer term. Indeed, with the current spread of record low savings rates on offer, this is the only way to attempt to mirror the yields previously offered by the more traditional savings plans.
Weigh up the options
Ultimately, which option or blend of options will depend entirely on your individual circumstances however, these remain 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 set to continue, 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.
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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