BoE, Inflation and What You Need To Know, Now

Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.

BoE, Inflation and What You Need To Know, Now

Last week The Bank of England (BoE) announced that their benchmark interest rate will remain at its historic low of 0.1%. This came as a surprise to market participants primed to expect a rise.  Only last month BoE Governor Andrew Bailey commented that the Monetary Policy Committee would have to act to tackle inflation; these comments coming after the BoE’s highest inflation forecast in a decade.

While a rate rise remains likely, possibly happening next month, the uncomfortable truth for individuals with cash savings in the bank is the value of their money is increasingly eroding. In simple terms the purchasing power of a pound falls to ninety-five pence one year forward if inflation is 5%.

One of the ways economists express the effect inflation is by calculating Real Rates.  If the interest rate received is less than the rate of inflation, the measured outcome is negative i.e. a Negative Real Rate. Conversely, if the interest rate is higher investors receive a Positive Real Rate.

It should be noted that economists talking about real rates are taking aim at bond investors buying gilts (UK government bonds) which have longer term horizons than demand deposits. They match up the yield paid on a bond against an inflation rate which is based on inflation expectations over the same period i.e a 10-year bond will be matched against a 10 -year inflation expectations forecast.

However, as we are referencing the impact on cash savers, we have produced a chart which subtracts the annual inflation rate from the UK base rate. The base rate is not an exact measure of the rate paid to savers, but it is close enough to provide a decent representation of the inflationary impact on savers money in the bank.

Chart 1: UK Real Interest Rates (%) 2000-2021

Source: Bloomberg, November 2021

The chart tells us that ever since the financial crash cash savers have been inadequately compensated against the effects of inflation stretching out now over a period of 13 years! Of course, this isn’t new news but, and this is the surprising part, over 55% of people in the UK hold all their savings in cash accounts. Only 14% are investing their money to try and beat inflation. Indicating there is a serious knowledge gap that still needs to be addressed.

Individuals in a typical high street bank getting 0.01% on a standard savings account are being £10 for every £100,000 deposited. In the decade pre 2008 the average interest rate was 5%, producing £5,000 of annual interest income! Moreover, the income generated back then was ahead of inflation allowing savers to preserve and grow their wealth in real terms.

Economists use a term called Financial Repression to describe what is currently happening to savers. This occurs when governments use tools at their disposal drive down the cost of borrowing for themselves, but at the expense of all savers in accounts paying a fixed rate of interest. The so-called quantitative easing (QE) monetary policy that has been deployed 4 times since the financial crash.

However, as explained, the pernicious effect of QE on savers is not just the paltry rate of interest paid to them. The pain inflicted, in an even more hurtful way, is through recent sharp increases in inflation. Central banks are at pains to mark this inflationary surge as transitory, and hopefully this will be true, but savers need to be even more aware of the negative effects of inflation on their wealth.

The BoE say they envisage inflation reaching 5% next spring. With this in mind they seem to acknowledge interest rate rises will be needed, but, and it is a big BUT, given their desire to keep the economy moving ahead we should expect small rises and at a slow pace. The term forecast for interest rates suggests an initial rise to 0.25% with 2 further rate hikes next year taking the base rate to 1% by the end of 2022.

Concluding Thoughts

  • If the interest rate forecast for 2022 is correct and the BoE’s own 5% inflation forecast proves correct, savers are set to continue to lose money in real terms.
  • While it is imminent that the interest rate will increase in the coming months. It is only expected to go from extremely low, to very low at 0.25%.
  • Real interest rates could be sitting at an eye watering negative 4.75% next year.
Global Markets, Investing