Cost of living crisis: How could rising interest rates affect you?

The cost of living crisis continues to impact consumers’ pockets as prices of everyday goods and services, such as food and energy, keep climbing higher.

But a secondary impact of inflation (higher prices) is that interest rates tend to rise, and this also has consequences for your finances.

Government help is limited…

Price rises are needed for a healthy, growing economy, but the desired annual rate of price rises is around 2%. When prices rise at a much higher rate than this, there are things that the government can do to help consumers. A current example is the £400 grant that all households are receiving to help with rising energy bills. Whilst this is welcome, it is only temporary, and falls short of covering the entire increase for many consumers.

Furthermore, although it will feel like bills are lower as the grant goes into people’s accounts, the headline retail price of energy is still increasing, keeping the rate of inflation at multi-decade highs.

…but the Bank of England can do more

The government cannot force private goods and services companies to lower their prices. But the Bank of England (BoE) has more tools at its disposal. When prices rise faster than the BoE deems healthy for the economy, one tool it can employ is to raise the base rate of interest.

Companies that offer borrowing products to consumers, such as mortgages, personal loans, car loans, credit cards and so on, will link the rate of interest they charge on these products to the BoE’s base rate. If the base rate rises, so will the interest rates on these products.

Higher interest rates mean it is more expensive for consumers to pay back these debt products. This encourages people to spend less so that they can afford to pay back their debts. The less people spend, the lower inflation should eventually be.

And this is what the BoE has been doing throughout 2022:

Source: Bank of England, December 2022: Bank Rate history and data | Bank of England Database

Double whammy for consumers in the medium term

The desired effect of raising interest rates takes time to feed through to consumer spending habits. This means consumers will keep on spending for a period of time while interest rates are increasing, meaning that prices and interest rates can rise at the same time, before prices begin to plateau and fall.

For consumers, this can result in the double whammy of increased prices and increased debt repayments for a period of time.

Indeed, both prices and interest rates are forecast to continue increasing well into 2023 (1).

What does this mean for those with mortgages?

To illustrate, let’s look at a mortgage of £320,000 to be repaid over 30 years, at a range of interest rates:

Source: Experian, September 2022, What Will Your Mortgage Payment Be at 6%? - Experian

At 6% you are paying nearly £7,000 more a year than if your rate of interest was 3%.

Don’t have a mortgage?

You may be breathing a sigh of relief if the above section doesn’t apply to you. But even if you have savings rather than a mortgage, don’t assume there’s no need to look at your finances. The interest rate being paid on savings accounts will tick up as the base rate increases, but this is unlikely to keep up with the rate of inflation, which means your savings could be losing value in real terms.

Don’t lose your fortune

Your personal fortune is whatever sum you have worked hard to save, it doesn’t have to mean millions. You’ll want to do what you can to make sure it doesn’t lose value. But with a backdrop of high inflation, recession, continued cost of living crisis and conflict in Ukraine, it is challenging to know where to put your money. This is when professional advice has the potential to help you understand what you want to achieve with your money, and explore ways in which you can work towards those goals.

There are opportunities…

It is a challenging environment for all companies, as the costs of their raw materials increase along with the cost of their energy. Businesses do not enjoy the same protection of the energy price cap that applies to consumers, nor do they receive government grants like UK households are currently benefiting from. However, for cash-rich companies, rising interest rates are good as it means they can invest their cash and earn interest. This could put them in a stronger position to bounce back when the economic backdrop is more favourable.

…if you know where to look for them

The challenge for investors is doing the research to identify companies that are holding cash, and that they are being sensible about how they are investing it. Active fund managers have access to management teams to ask companies about their finances, and they also have experts who can analyse company accounts to make informed decisions about the health and prospects for individual businesses.

As well as having the expertise to find the companies best placed to survive and prosper from the current difficult economic backdrop in the UK, active fund managers will also be looking further afield, to economies that might be faring better than the UK.

It is a challenging time for consumers and investors, but if you do have savings, now could be a good time to revisit where you have them and what you want to use them for. The financial backdrop is different now to six months ago, and a review of your current situation may highlight changes in your goals as well as changes in the best way to work towards them.

Sources:

(1) Bank of England, 8 December 2022 When will inflation in the UK come down? | Bank of England