Interest rates and inflation - what does this mean for you?

Why has inflation increased?

Whilst the news continues to be dominated by the terrible events in Ukraine, the impact on the global financial system is unfolding before us. The cost of energy has soared, which has impacted both individuals and businesses. This has been compounded by a shortage of materials such as plastic and concrete and high demand for the services of shipping companies who transport the goods that we buy around the world.

This increased cost of producing goods & services for businesses have been passed on to consumers in the form of price rises with inflation in the U.K. reaching 5.5% in January 2022, its highest increase since February 1991.

Why are interest rates relevant?

To combat inflation, the Bank of England (and central banks all over the world) are gradually increasing interest rates in an attempt to ‘cool’ the demand for goods & services. This makes it more attractive to savers to ‘park’ their money in the bank whilst also increasing the cost of borrowing money.

For most people this higher cost of borrowing results in increases to their mortgage payments. The Bank of England hopes that the higher cost of borrowing will mean people have less to spend on other goods, gradually reducing the demand for goods & services which drives down prices.

What does this mean for your money?

It might seem counterintuitive to raise costs on mortgages to save money on goods & services, but all else being equal, the insidious impact of inflation is to lower the real value of your money over time. In the short-term it might seem unpalatable to see the amount spent on debt rise, but the avoidance of long-term levels of high inflation or hyperinflation is key to the Bank of England’s monetary policy.

The worst example in the U.K.’s history of the impact of long-term high levels of inflation was the 1970s, where inflation stayed above 7.6% for the entire decade. To put that into perspective, £100 cash on the 1^st of January 1970 was worth about £24 on the 31^st of December 1979.

Cash is only one of the various assets impacted by inflation and considering how your investments (typically Bonds and Shares) will react should also be considered:

Bonds

• The key risks involved in bonds are:

• The financial strength of the entity the money is lent to

• How long the money is lent for

• What does inflation mean for bonds?

• The annual interest payment a bond pays an investor is fixed. Therefore, if inflation increases, the real value of this fixed annual payment decreases.

• What do interest rate rises mean for bonds?

• Using an example of a £1,000 loan to the UK government, generating 1% a year. This is an attractive investment if a low-risk alternative is putting money in the bank, earning 0.2% interest.

• However, if interest rates rise and the investor could instead make 2% in the bank, the 1% annual payment from the government looks much less attractive.

• Therefore, when interest rates rise, the value of the bond goes down to compensate new investors for the interest rate no longer being as attractive.

Shares

• The key risks involved in shares are:

• Future performance is not known or guaranteed

• Market fluctuations can be sudden and severe

• What does inflation mean for shares?

• The impact can vary substantially between different types of company.

• On one hand, the value of dividends paid out is decreased in much the same way as bond payments. However, because companies can alter their costs and prices, they can still continue to trade profitably when inflation is high. Therefore, share prices can continue to grow.

• What do interest rate rises mean for shares?

• Again, this depends on the type of company.

• For businesses that have high levels of borrowing, rising interest rates are an issue. However, for those without substantial borrowings, interest rates are less of a factor.

Historically, shares have offered better protection against inflation than bonds or cash. However, increasing your allocation to shares at the expense of bonds or retaining money in cash increases the volatility of your portfolio. It makes little sense to take on undue investment risk to avoid inflation risk.

What should you do?

1. Remember that investing is a long-term discipline.
2. Accept that inflation is a risk that can be mitigated by investing rather than retaining cash, however, it is not a risk that can be removed.
3. Avoid trying to predict the future. There is no way of knowing which asset class is going to perform best over the coming weeks, months and even years.
4. Ensure you are invested in a diversified portfolio. For most people, this means diversifying between shares and bonds. For everyone, it means diversifying globally.
5. Base the level of risk you take on a long-term, stress-tested financial plan
   

If this article has inspired any further questions, or if you wish to discuss your personal situation further, please get in touch.

The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. It represents our understanding of law and HM Revenue & Customs practice. You are recommended to seek competent professional advice before taking any action.

Tax and Estate Planning Services are not regulated by the Financial Conduct Authority.