How interest rates and inflation affect your finances

Inflation and interest rates affect our everyday lives. Whether you’re buying groceries or starting a business, these key economic factors play a crucial role in shaping your financial wellbeing.

Inflation refers to the increase in the price of goods and services over time. For example, if a loaf of bread cost £2 last year and this year costs £2.20, the year-on-year inflation of that item is 10 percent.

As inflation rises, the purchasing power of your money falls. To use the above example, if a £2 coin can no longer buy a loaf of bread, that coin is said to have less purchasing power. In other words, the ‘nominal’ value of the £2 coin remains the same, but its ‘real’ economic value has fallen. As a consumer, this means your paycheque won’t stretch as far. You may find yourself with less money to put away in savings or spend on non-necessities, such as travel or dining out.

That said, inflation isn’t inherently bad and, for many of us, its impacts are generally lessened by pay rises we receive from our employers. In fact a small amount of inflation, of about 2 percent, is generally considered appropriate to keep an economy ticking along (1).

When inflation climbs too high, it’s usually due to one or more of the following factors:

• Demand-pull inflation takes place when the demand for goods and services rises sharply. For example, after the Covid lockdown ended many people decided to travel, causing high demand in the travel industry.

• Cost-push inflation happens when the total supply of goods and services that can be produced falls. For example, during times of war it may become difficult to access essential materials for building. This can lead to a rise in building material costs.

• Built-in inflation happens when workers believe inflation will continue, leading them to demand higher wages to maintain their standard of living. These wage increases are then passed on to consumers as price increases. This process can be repeated multiple times, a phenomenon known as a ‘wage-price spiral’.

Different types of inflation

There are several ways to measure inflation.

Core inflation excludes food and energy, whose prices fluctuate substantially due to factors including weather and geopolitical events. By excluding these items, core inflation aims to provide a more stable measure of the underlying trend of inflation. But food and energy are some of the most important costs for individuals, meaning core inflation can fail to capture the impact of inflation on households.

Headline inflation is a measure of the total inflation in the economy, including food and energy. The UK and many other countries use the Consumer Price Index (CPI) as a measure of headline inflation. CPI is a ‘basket’ of more than 500 commonly purchased goods and services; it provides a representation of how the average person spends their money.

CPI includes the cost of rent but does not include housing costs for owner-occupiers. Adding these costs creates a measure called CPIH(CPI plus Housing). CPIH aims to provide a more comprehensive measure of inflation by including housing costs for a far wider section of society.

Interest rates: a tool to control consumer spending

When inflation becomes too high, central banks such as the Bank of England (BoE) use interest rates as their main tool to try to bring it down.

In response to high inflation, the BoE will typically raise the base interest rate (or ‘Bank Rate’), which is the interest rate the BoE charges other banks on loans. So an increase in the Bank Rate has a domino effect on every other loan rate, raising interest rates throughout the economy.

Raising interest rates reduces inflationary pressures because consumers generally have less money to spend. When overall spending in the economy slows, businesses are forced to offer more competitive prices to keep their customers, meaning price rises slow down and inflation falls.

But ‘falling’ inflation does not mean goods and services become cheaper. Rather, it means prices are rising at a slower pace than they once were.

Higher interest rates reduce consumer spending in several ways.

• Borrowing money becomes more expensive. As the cost of borrowing increases, people with debt, from a mortgage to a credit card balance, have less to spend on other items. Typically, consumers first cut their non-essential purchases, including travel and luxury goods. People on low-incomes often suffer the most, as they have fewer non-essential purchases and may have to cut back even on the necessities of food and housing.

• An incentive to save more. When interest rates rise, rates on savings accounts go up. As a result consumers have an incentive to reduce spending and save money instead.

• Economic uncertainty. For the average person, higher interest rates may be the first sign that the economy is struggling. This can cause consumers to be more cautious with their spending.

‘Good times’ and ‘bad times’

For these reasons, periods of low interest rates and low inflation are generally considered ‘good times’ for people and businesses. Low inflation preserves the purchasing power of money, meaning consumers feel confident spending now as the value of their savings remains preserved for future spending.

Meanwhile, low interest rates mean the cost of borrowing is low, making it cheaper to take out loans to buy a home or start a business. Low inflation and low interest rates bring a sense of security, known as the ‘feelgood’ factor. Individuals and businesses feel more confident, bringing a collective sense of financial wellbeing.

On the flipside, periods of high interest rates and high inflation are generally considered ‘bad times’. As we saw above, inflation erodes the value of money, meaning consumers and businesses have less spending power. For businesses, that may mean cutting jobs, which contributes to unemployment.

When interest rates increase the cost of borrowing increases, which discourages people from taking out loans and makes it harder for them to pay back the ones they already have. These circumstances lead to hardship and a sense of financial uncertainty.

How interest rates affect housing

Homeowners

As interest rates rise, the media’s attention often shifts to the most important type of loan: mortgages. When the cost of home loans increases, people increasingly find themselves priced out of the housing market, either unable to secure a new mortgage or struggling to afford their current one.

Consequently, properties stay on the market for longer, prompting sellers to lower their asking prices to attract buyers. That means, as interest rates rise, property prices typically decline. In extreme cases, homeowners may find themselves experiencing negative equity, where the value of their property falls below the amount they still owe on their mortgage.

The impact of interest rates on a homeowner varies depending on whether they hold a fixed or variable-rate mortgage. Fixed-rate mortgages have a constant interest rate, shielding homeowners from fluctuations in the base rate. Variable-rate mortgages, by contrast, do not have a set interest rate and therefore expose homeowners to market rates.

But most mortgages only offer a fixed rate for a limited time. Once this period ends, homeowners suddenly find themselves exposed to fluctuating interest rates, which may have been increasing for several months. This could lead your mortgage payments to increase dramatically overnight, a situation known as a ‘mortgage cliff’.

Renters

Renters don’t own their property, but they are indirectly exposed to mortgage rate rises through their landlords. When rates rise, landlords often respond by raising rents on their properties; and landlords who don’t have mortgages may still increase rents in line with market rates.

Additionally, some landlords may opt to sell their properties. This could reduce the number of rental properties on the market and drive rents higher as tenants compete for the remaining options.

Taxes: another tool to control inflation

In the UK, the number of mortgage holders is shrinking. Rising property prices have led to a significant increase in renting, particularly among younger generations. At the other end of the spectrum, a growing number of people now own their homes outright (2).

With fewer mortgage holders, the impact of interest rates on consumer spending has decreased. One alternative tool that has been proposed is taxation, as changes to the tax system have a direct impact on how much households can spend.

Unlike monetary policy, which is controlled by the BoE, fiscal policy including tax rates is set by the government. But some groups have expressed concern that transferring responsibility for targeting inflation from the BoE to the government could make inflation management less effective (3).

If you are concerned about the impact of interest rates, inflation and taxes on your finances and wellbeing, then you may benefit from speaking with a financial adviser. At Schroders Personal Wealth one of our key principles is to have regular reviews with an adviser. This can help ensure you are well placed to deal with any economic challenges.

Sources:

(1) Bank of England (www.bankofengland.co.uk), ‘Why are interest rates high and when might they fall?’, 2 February 2024.

(2) Office for National Statistics (www.ons.gov.uk), ‘Subnational estimates of dwellings and households by tenure, England: 2021’, 27 February 2023.

(3) Forbes (www.forbes.com), ‘Why raising taxes is a misguided approach to inflation control’, 24 March 2023.