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Inflation & interest rates

Saving | Savings Accounts

By Justin Modray, published 13 August 2010.
Helpful? 72

In times of high inflation you'd normally expect interest rates to rise. So why haven't they? And are they likely to soon?

Inflation and interest rates are pretty fundamental to our everyday lives. Inflation affects our cost of living (and, to an extent, pay rises) while interest rates impact on our cost of borrowing and the return on our savings.

Because interest rates are a popular way for central banks (e.g. Bank of England) to try and control inflation, there’s usually a link between the two. High inflation is often caused by us all spending a lot – if our demand is high then manufacturers and suppliers can take advantage by raising prices.

Higher interest rates generally encourage us to spend less, as both the cost of borrowing and appeal of saving rises, which should (after a while) lead to falling inflation. And when inflation is falling central banks are more likely to get away with maintaining or cutting base interest rates.

The chart below generally supports this theory. There’s usually a lag between inflationary movements and interest rate changes, but the relationship between the two is apparent. Except for the last year or so where inflation has shot up but interest rates are flat at 0.5%. (You can view a dynamically updated chart here.)

There are two main reasons behind this.

  • Soaring inflation over this period hasn’t been caused by us all spending more – rather it’s mostly due to higher oil prices and a VAT rise.
  • Our economy has been in/on the cusp of recession. Raising interest rates during the current climate could be the straw that breaks the camel’s back – from an economic point of view we need to be encouraged to spend more, not less.

If we look at what contributed to June’s CPI figure of 3.2% then rising transport costs at 1.4% were by far the biggest factor. This was due to higher fuel prices and taxes – not a surge in our demand for travelling. The 1 January 2010 VAT rise from 15% to 17.5% is estimated to have added 0.4% to the overall annual change in CPI. So between them, rising fuel prices and VAT have accounted for the bulk of inflation. Higher food costs and alcohol/tobacco duties also made a small impact.

The point is, the above inflationary pressures are largely independent of consumer spending. So raising interest rates would make very little difference – other than almost certainly push us back into recession.

And with several years of tax rises and public spending cuts ahead of us I think the chances of our economy becoming sufficiently robust for the Bank of England to risk interest rate hikes is slim.

This is why it’s likely we’ll see interest rates stay low for quite a while yet, even though next January’s planned VAT rise from 17.5% to 20% will add inflationary pressure.

So fixed rate savings accounts (provided they pay a better rate than ‘best buy’ easy access accounts) and variable rate tracker mortgages will probably remain the most attractive options for some time yet, provided they suit your needs.

Note: I’ve used the breakdown for CPI and not RPI because the ONS has (strangely) stopped publishing the relevant RPI data.

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