What are inflation and interest rates? What form are they taking in 2022, and what does this mean for your wealth and finances? Despite sounding abstract, these two economic concepts have a big impact on household finances. Below, our financial planners at Vesta Wealth explain what these two terms mean, their current shape and trajectory in the UK and how these could impact individuals and families in the months ahead.
Inflation and interest rates – what are they?
Broadly speaking, inflation refers to the rise in price – overall – of goods and services in an economy, over time. If a household product costs £1 in 2021 but UK inflation rises by 5% in a 12-month period, then this product could rise in price to £1.05 by 2022. This means that your pound has lost purchasing power. What you could buy for a pound in 2021 can no longer be purchased in 2022. You need to spend more money to get the same quality and quantity.
Nobody wants inflation to run out of control. Yet stagnant or shrinking overall prices (deflation) also is typically avoided by central banks, since this usually means the economy is not growing e.g. less wage and job growth. This is why the Bank of England (BoE) has a target of 2% inflation to try to keep prices under control whilst allowing the economy to grow. The primary way it achieves this is by setting the UK’s overall interest rate (the base rate).
If the BoE raises interest rates, this tends to act as a brake on inflation if it is rising too fast. This is because high street banks tend to alter their own interest rates with the base rate. So, if the latter rises then so do their own. Bank customers can then access better rates on their savings accounts, creating an incentive to save more. When enough people do this, it results in less spending in the economy. This, in turn, helps to cool down overall price growth (inflation).
The UK economic landscape in 2022
Interestingly, in 2021 both UK inflation and interest rates had been historically low for some years. Inflation averaged 2.5% from 1989 until 2021, and between 1971 and 2021 the UK base rate averaged 7.21% (although since 2010 it has been well below 1%).
The big catalyst for change in the UK economy has, of course, been the pandemic. Following the arrival of national lockdown measures in March 2020, the BoE implemented its response by cutting the base rate, twice. First, it was lowered to 0.25% (from 0.5%) and then lowered again to 0.10%. This was partly to help businesses and households access cheaper loans during the lockdown months. However, the lifting of lockdown in late 2021 led to another big change.
During the Autumn, it became clear that the UK was experiencing rising, persistent inflation. By November, it stood at a 10-year high of 4.2% but had risen further to 5.1% by the start of 2022. Many commentators attributed this to a surge in consumer spending as the economy reopened, as well as rising energy prices in the run-up to winter. In response, the BoE raised the base rate in December 2021 back up to 0.25%.
Implications for financial planning
These developments raise big questions for 2022. Will inflation keep rising? If so, will the BoE be forced to raise interest rates even more, to try to meet its 2% inflation target? What would this mean for workers, businesses, savers and investors across the UK?
Of course, nobody knows what will happen. Perhaps Omicron – or some other variant – proves to be more serious than currently thought, leading to other strict lockdowns. If this happens, inflation would perhaps fall again, as fewer people go out to spend money, and interest rates could be lowered, similar to the UK economic picture in early 2020. Alternatively, perhaps the UK does not re-enter lockdown in 2022 and covid is brought under more control. In which case, current interest rates may be enough to cool down inflation.
Given the uncertainty around the pandemic and the economy, it is wise to prepare your wealth and finances for a range of scenarios. A good starting point is to ensure you have a strong reserve of emergency cash (3-6 months of living costs) in case hard times fall upon your household. It is also wise to review your financial protection – such as life insurance and critical illness cover – to ensure these are up to date.
If you would like to discuss your financial plan and retirement strategy, then we would love to hear from you. Get in touch with your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England. Reach us via: t: 01228 210 137 TThis content is for information purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.Invitation