After more than a decade of low interest rates, the Bank of England (BoE) has suggested that it will continue to gradually increase its base rate. With savers suffering from low returns, is that good news?
In December 2021, the BoE increased its base rate from 0.1% to 0.25%. While still very low compared to the Bank’s base rate historically, it’s the highest it has been since the start of the pandemic in 2020. Interest rates have been low since the 2008 financial crisis, when the BoE reduced rates in a bid to support the economy. As the UK recovers from the pandemic, the base rate could steadily begin to climb.
While, on the surface, the rate hike looks like good news for savers, it may not be as positive as it first seems.
To start with, the interest you’re receiving on your savings may not have increased following the announcement. According to a Guardian report, five weeks after the BoE announcement just four financial firms had passed on the full rate rise to all, or nearly all, of their variable-rate savings account customers. So, you may not have seen a change in the interest your savings are delivering at all.
Why does inflation exceeding 5% reduce the real-terms value of your savings?
One of the key reasons behind the decision to increase the interest base rate was rapidly rising inflation.
In the 12 months to December 2021, inflation hit its highest rate for 30 years. The rate of annual inflation was 5.4%, which means that the cost of living has increased much faster than the BoE’s target of 2%. At the current pace of inflation, something that cost £1 last year will now cost £1.05. That may not seem like a huge difference but when it’s across all your spending, from holidays to electricity, it adds up and can place pressure on your finances.
Inflation doesn’t just affect your day-to-day budget either – it also affects the spending power of your savings.
While the money sitting in your account doesn’t decrease, its spending power does if the interest earned is lower than inflation. So, unless your savings are earning interest above 5.4%, they are losing value in real terms as you’ll be able to buy less with that money.
Again, it’s something that can seem insignificant when you first look at it. However, over a sustained period, it does affect the value of your savings.
The BoE’s inflation calculator demonstrates this. If you had £20,000 in a savings account in 2010, it would need to have grown to £26,225.20 in a decade to maintain its spending power. This is because the average annual inflation was 2.7%. Now imagine how much your savings would need to grow to keep pace with inflation of 5.4%.
So, what can you do to maintain the value of your savings? Investing could provide a solution.
First, it’s important to note that cash savings can still play an important role in your overall financial plan. For example, your emergency fund should be readily accessible in case you need it, so a cash account often makes sense, even if interest rates are low.
When does investing make sense as a strategy to beat inflation?
Investing can help your savings to grow at a pace that maintains or exceeds the rate of inflation. As a result, it can help you maintain or grow your spending power over time. However, it does come with risks.
The value of investments can rise and fall, and you will experience periods of volatility, so investing should be done with a long-term outlook. If you’re saving for goals that are more than five years away, whether that’s helping children get on the property ladder or planning for retirement, it can make sense. If your savings are for short-term goals, like going on holiday, investing may not be right for you.
This is because a long-term time frame gives the peaks and troughs of market movements a chance to smooth out. If you’re investing for a short-term goal, what happens if you need the money at a point when your investment values fall? It could mean you have to cancel plans or sell more units to achieve the same goal, which could have a knock-on effect for other goals.
If you already have a rainy day fund for unexpected costs and plan to save for more than five years, it is worth thinking about whether investing is appropriate for you. We understand that you may have concerns about investing and the associated risks, but we’re here to offer you support in understanding your risk profile, choosing investments, and reviewing their performance. Please contact us to discuss what steps you can take to reduce the effect of inflation on your wealth.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.