What impact could the Budget have on inflation and interest rates and how might this affect me?
- Shunil Roy-Chaudhuri
- 29 October 2021
- 5 mins reading time
The Consumer Prices Index (CPI) fell to 3.1% in September from 3.2% in August, but remains above the Bank of England’s 2% target, as it has done almost every month since May. In the autumn Budget, Chancellor of the Exchequer Rishi Sunak said the Office for Budget Responsibility (OBR) forecast that inflation would average 4% over next year. He also pointed out that a 1% rise in inflation or interest rates would cost taxpayers £23 billion.
The Budget offered little in terms of specific measures to counter inflation, but, in our view, some government policies introduced prior to this Budget may do so. They include an increase in National Insurance and Corporation Tax and the freezing of pension personal allowances.
Inflation measures how much the average prices of goods and services rise over time. It is generally estimated by comparing the cost of items today with what they cost 12 months ago. The inflation rate is the average increase in these prices.
The UK has two main measures of inflation: the Consumer Price Index (CPI) and core inflation. These both reflect the cost of a typical basket of goods, based on patterns of consumer consumption. However, core inflation excludes prices from the energy and food sectors, which are often more volatile.
The Government has set a 2% CPI inflation target for the UK. If inflation rises too much above this level, it can be hard for consumers to budget effectively or for businesses to set their prices correctly.
Impact of Covid-19
The increase in CPI is due to something called reflation, which happens when prices rise as the economy strives to achieve full employment and growth. We see this now with the easing of Covid-19 restrictions and the re-opening of the UK economy.
In theory, company shares can benefit from rising inflation, as price increases often go hand in hand with increases in revenues, which can lift share prices.
In contrast, bonds can lose out to inflation. A bond is a loan from an investor to a borrower, such as a company or a government. Bonds usually pay investors a fixed stream of interest payments, and this becomes less valuable if the cost of goods and services rises, reducing bond prices as a result.
Richard Allan, Personal Wealth Adviser at Schroders Personal Wealth, said: ‘When advising a client we consider their appetite for investment risk and this will lead us to build an investment portfolio that is diversified across various types of assets, including shares and bonds. When inflation rises or falls this will impact different investments in different ways, so it’s important to have a mix.’
Cash can also lose out to inflation. A key advantage of cash is it can offer a financial safety net if required. However, its value can diminish over time, if the rate of interest paid on the cash is below the level of inflation. However, Richard Allan pointed out: ‘Inflation isn’t always a bad thing, particularly when it comes to borrowers. For those with debts and mortgages, the impact of inflation is to reduce the value of the debt in real terms.’
Read more: How could rising inflation affect me?
Government policies and inflation
The three government policies cited earlier in this article, all of which were flagged up before the autumn Budget, could have a dampening effect on CPI.
First, the increase in the National Insurance rate from 12% to 13.25% from April 2022 will reduce the spending power of UK consumers. This could reduce economic demand and, consequently, limit inflation.
Second, the freezing of the lifetime allowance at £1.073 million means some pension investors may now have to save more to meet their retirement plans. This allowance limits how much people can save for retirement throughout their working lives. Retirement savings above this limit are subject to tax. This could also reduce economic demand and dampen inflation.
Third, the increase in tax on company profits from 19% to 25% from April 2023 will leave firms with less money to invest in their businesses and to pay out as dividends to shareholders. This, again, could dampen economic demand and inflation.
Why an interest rate rise could be delayed
Interest rates are one of the main levers the Bank of England uses to try to control inflation. In theory, a rise in interest rates will reduce inflation.
UK interest rates are currently at a historically low level of 0.1% and some commentators expect this to rise when the central bank’s Monetary Policy Committee meets on 4 November. However, we think these policies may help inflation to reduce over time. We believe the Bank of England may share this view and so could delay raising interest rates.
Any views expressed are our in-house views as at the time of publishing.
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