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Inflation & Interest Rates

You must have heard these terms in the news and lately a bit more than usual. I'm sure you have a general understanding of what they mean, but I'd like to dive in a little deeper and try to highlight how this might affect you.

When thinking about your personal finances it is great to analyse your personal situation and where you want to get to, however it is also important to understand what is happening around you in terms of global and local economics. This is known as macroeconomics (one of my favorite topics at uni). You can read about Monetary & Fiscal Politics implemented by the government during the 2020 recession here.


What is inflation and how is it measured?

So what is inflation? This is a term used to refer to the general increase in prices and it is measured by the consumer price index known as CPI. It is estimated by using consumer price indices. One way to understand a price index is to think of a very large shopping basket containing all the goods and services bought by households. The price index estimates changes to the total cost of this basket.

The indices are used in many ways by the government, businesses and society in general. They can affect interest rates, tax allowances, wages, state benefits, pensions, contracts and many other payments. They also show the impact of inflation on family budgets.

The Consumer Prices Index including owner occupiers' housing costs (CPIH) is the most comprehensive measure of inflation. It extends the Consumer Prices Index (CPI) to include a measure of the costs associated with owning, maintaining and living in one's own home, known as owner occupiers' housing costs (OOH), along with Council Tax.

What categories are measured in inflation?

The upward contribution of 0.33 percentage points to the change in the CPIH 12-month inflation rate from housing and household services was a result of price rises of 9.4% and 9.1% for gas and electricity, respectively, between March and April 2021.

Throughout 2020, clothing and footwear prices followed a different pattern compared with previous years. Usually, from the start of the year, clothing and footwear prices rise steadily, but, in February 2021, increased discounting meant prices fell. Between February and March 2021, discounting reduced and prices rose by 1.6%.

There were further increases between March and April 2021 with clothing and footwear prices rising by 2.4%, compared with a fall of 1.5% a year ago. As a consequence of the first nationwide lockdown, in April 2020, there were a greater number of items recorded as being discounted (when compared with previous years), which potentially reflected retailers’ efforts to encourage online purchases.

What are some of the consequences of inflation?

Another important factor about inflation is the loss of the value of money. Have you ever heard an elder family member say "prices are just not what they used to be, everything is so expensive now"?. Think of something in your life time you can use as a bench mark. Like the cost of a bus ticket, or a train card? Say it used to cost you 50p per bus ride, and now it costs you 2.50 pounds. That means with the same amount of money 15 years ago you could have gotten 5 bus rides, while today with the same amount of money you can only ride once.

This is what happens to your money over the long term, it looses value. Think of inflation as a tax on your money. This is why holding you month in cash is not ideal over the long term and why investing in the stock market is a viable option.

So how does inflation correlate with other macroeconomic measures? Well lets look at what it does with interest rates.

Interest Rates

Interest is what you pay for borrowing money, and what banks pay you for saving money with them. The Bank Rate is the most important interest rate in the UK. In the news, it's sometimes called the ‘Bank of England base rate’ or even just ‘the interest rate’.

It's part of the Monetary Policy action taken to meet the 2% target that the Government have set to keep inflation low and stable. These are very interesting times as just today it has been announced that May's inflation has now surpassed this rate at 2.2% in the U.K.

The Bank Rate determines the interest rate paid to commercial banks that hold money with the Bank of England. It influences the rates those banks charge people to borrow money along with what they will pay on their savings.

A change in the Bank Rate affects how much people spend. And how much people spend overall influences how much things cost. So changes in the Bank Rate can influence prices and inflation.

If rates fall and you have a loan or mortgage, your interest payments may get cheaper. And, if you have savings, you may be paid less interest. If interest rates fall, it's cheaper for households and businesses to increase the amount they borrow but it's less rewarding to save.

Can we take a moment to look at this graph and see what the interest rates were not so many years ago? In the 90's rates where as high as 15%. For those currently buying a property and calculating their mortgage payments, could you possibly imagine your monthly expenses at such a high percentage?

Here is a simple example based on a property value of 300k wth a 10% deposit and a 2% interest rate which would imply monthly payments of 995. Should the interest rate go up to 5%, then your monthly payments would rise to 1,449 and if it increases to 10% then to 2,369 and finally if as high as 15% then payments would be 3,414. Interesting, right?

Now why is it important to pay attention to what is happening around you? Another thing you can see is that there is a clear correlation between the inflation movements and the interest rates. If inflation is starting to increase, there is a higher possibility that the interest rate might follow.

It is also important to be aware of what has happened in the past and the reason for certain actions taken. As an example, between 2003-2007 inflation rates where raised significantly as an attempt to reign in what was perceived to be an over inflating economy. Rates rose from 3.5% to 5.75% in this period.

In the time frame of 2007-2017, due to the financial crisis the base interest fell to its lowest level for 300 years. Dropping fro 5.75% to as low as 0.25% in 2016.

So what are we seeing in the news now? Inflation is rising driven by owner occupiers' housing costs (OOH) which has been a reflexion of many schemes created to increase demand such as the stamp duty holiday, the 95% LTV Mortgages, etc. On the other hand you also have the lifting of restrictions which is increasing spend on clothing, retail and recreation.

Some analysts have predicted the highest economic boom since WW2 is to come (of course this is just speculation). Most businesses will try to make up for lost times by trying to increase prices, hence driving inflation up. So if the government wants to control the rising rates of inflation, will they start increasing the long over due interest rates (Monetary policy)?

What are your thoughts on how things will evolve? I'd love to hear your opinion. Here is a video I've created on the topic as I know some of you prefer when I break it down on video :)

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