Understanding the impact of interest rates and inflation on your investments

A Stack of Coins - Inflation visualised

Investing

Gareth Trainor

13th December 2017 at 12:00pm

On 2 November 2017, the Bank of England announced the first increase in interest rates since July 2007 on the back of inflation reaching 3% in September.

What’s been happening? What’s the longer term outlook for UK interest rates and inflation? And, most importantly, what does it mean for your investments?

First things first – what are interest rates?

Interest rates are how much a lender will charge a borrower when they take out a loan. It’s usually shown as a percentage of the total amount loaned and there are hundreds of different interest rates between lenders and borrowers.

The Bank of England uses the base rate as a tool to control inflation

In this article we’re specifically talking about the interest rate set by the Bank of England – commonly known as the base rate. In the US, the base rate is set by the Federal Reserve and in the Eurozone by the European Central Bank.

How does the base rate affect you?

The rate that a central bank, such as the Bank of England in the UK, charges to commercial banks has an impact on what they charge you for loans and mortgages, and also what interest rate you get for saving with them.

So the cost of borrowing and the returns on your savings depend to a large extent on the interest rate set by the Bank of England.

If the base rate falls, banks can get money at a cheaper rate, meaning the cost of mortgages and other loans usually falls too – which is good news.

The not-so-good news is that you won’t be earning as much interest on your savings.

The base rate plays a crucial role in economic policy too

The Bank of England uses the base rate as a tool to control inflation. This is because the higher the base rate, the more incentive individuals and businesses have to save rather than borrow money: they’ll be getting higher returns from their savings but have to pay more for any loans.

So if inflation gets too high, the Bank of England may increase the base rate to encourage us all to spend less and to save more. In turn, this can help to bring price rises – inflation – back under control.

And that’s just what’s happened – inflation has been rising

The Bank of England currently has an inflation target of 2%. But inflation has exceeded that for most of 2017, and it reached a five-year high of 3% in September (source: Office for National Statistics Consumer Prices Index).

Despite the base rate rise, interest rates continue to be at historically low levels

It isn’t only the UK which has experienced rising inflation – the rising price of commodities, including oil, has led to upward inflationary pressures globally. Another factor is bad weather, which has affected the production of some crops – you may remember the lettuce shortage hitting the headlines in February.

However, one factor which is more specific to the UK is the weakening of sterling since the Brexit vote.

Although this has been a positive factor for UK companies exporting goods, it’s meant increases in the costs of imported goods.

The impact of this can’t be underestimated – we still import a considerable amount of the food we consume and the energy we use. Many consumer electronics, such as TVs, laptops, tablets and mobile phones, are also produced overseas.

So the Bank of England has acted, and raised the base rate by 0.25% to 0.5%.

What’s next for the base rate and inflation?

The Bank of England has repeated that “any future increases in Bank Rate would be expected to be at a gradual pace and to a limited extent”. It also believes that inflation is likely to have peaked above 3.0% in October.

Andrew Milligan, Head of Global Strategy at Standard Life Investments, expects another increase next year, and perhaps again in 2019, but believes it’s very data dependent.

He also thinks the Bank of England will want to move slowly given the large debt burden facing some parts of the country.

What does this mean for savings and investments?

Despite the base rate rise, interest rates continue to be at historically low levels, and there’s no indication that the Bank of England will now embark on a series of large hikes. So, although the situation for savers has improved, the interest available on most savings accounts is still lower than the rate of inflation.

Rising inflation means that the income you get from bonds won’t be worth as much. Investing gives you the opportunity for returns above inflation over the longer term.

But of course it carries more risk and investments can still be affected by interest rates and inflation, both positively and negatively.

You could get back less than you paid in and of course you can’t rely on past performance.

As a result, bond prices tend to fall as they’re less attractive to investors. However, rising, but still fairly low inflation and low interest rates are generally seen as positive for equities. Commodities (things like oil, gas, metals, wheat and coffee) also tend to do well when inflation is rising.

The important thing to remember is that investing is for the long term and no single type of investment will provide strong returns in all economic conditions.

Having a well-diversified portfolio, where your money is spread across a variety of investments from different parts of the world can help you achieve the right balance between risk and return, whatever’s happening in the economy and markets.

If you don’t have the time or inclination to build and manage a portfolio like this yourself, there are investment options that can do this for you.

The information in this blog or any response to comments should not be regarded as financial advice and is based on our understanding in November 2017.