Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

The rate of inflation bears so much influence on our money. Most simply, it erodes the value of it.

Consider the inflation surge of the last few years. If you were spending £1,000 a month in living costs in 2020, you’d now need to find £1,223 each month. That rise over four years has been particularly sharp in a historical context. Consider what happened in the decade before - a period when inflation averaged 2% a year. Between 2010 and 2020, £1,000 of costs grew to £1,216, according to the Bank of England’s inflation calculator.

The peak in the consumer prices index (CPI) was 11.1%, a 42-year high reached in October 2022. It wildly exceeded the ceiling that the Bank of England is tasked with maintaining - just 2%.

But finally, after four years, inflationary pressure is easing back to more usual levels.

Figures from the Office for National Statistics published today showed a sharp fall in CPI from 3.2% to 2.3%.

Why did inflation spike?

The inflation surge that came after the Covid pandemic was, like most things in economics, about supply and demand. Supply chains were crippled during the many phases of lockdown. Demand surged as the crisis abated and the price of nearly everything began to rise. Then Russia’s invasion of Ukraine in February 2022 delivered an additional crunch to supply, not just because one of the world’s largest producers of wheat and sunflower oil could no longer harvest, but because of the embargoes on Russia that sent energy prices soaring. Fear of further escalation, and growing tensions between the US and China, only added to price pressure.

While the war continues and geopolitical tensions remain high, particularly in the Middle East, supply and demand are in closer sync and inflationary pressure has eased.

One extreme example of price swings has been in car prices. A crunch in supply of new cars, with parts unavailable, had a startling effect on second-hand prices. The chart below, from ONS data, shows the annual growth rate of second-hand car prices peaking at more than 30%.

…and why is inflation falling?

As supply and demand has swung back to balance for most parts of the economy, inflation is getting closer to the 2% longer term trend rate for the UK. It is also lower than the Eurozone at 2.4% and the US at 3.4%.

The large fall for the UK in April was mostly because energy regulator Ofgem ordered a 12% reduction in the household energy bills cap, itself a result of falling global gas prices. The 27.1% fall in gas, electricity and other fuel prices was the largest on record.

Pressure is also easing elsewhere. Recent data from research firm Kantar showed grocery prices rose at an annual rate of 2.4% in the four weeks to mid-May, down from 3.2% the previous month.

More recently, the Prime Minister called for a general election on 4 July - which could add a layer of uncertainty.

What next?

While it might be bumpy, economists mostly forecast inflation to remain relatively low. They expect average annual rises of 2% in the third quarter, rising to 2.3% for the fourth quarter. Much depends, as has been the case for several years, on whether pay rises can be contained. Bigger wage settlements stoke demand and price pressure, which increases pressure for more wage rises.

Official forecasts imply this is unlikely. After the Spring Budget, the Office for Budget Responsibility (OBR) forecast inflation to fall and to remain below 2% until autumn 2027. Although since then, the UK has exited a brief recession and the US economy has not only avoided a hard landing but is growing at a solid pace.

 

What does it mean for interest rates?

The Bank uses interest rates to control inflation by cooling demand, hence the many hikes in rates during 2022 and 2023 which left us with today’s bank rate of 5.25%.

At the start of the year, rates were expected to start falling almost immediately. But with inflation holding up and the economy performing better than feared, rate cuts failed to materialise - the Bank needed to be sure that inflation was going the right way.

As of Monday, money markets priced in a 40% chance of a rate cut at the next Bank announcement in June. They also implied a further reduction, to 4.75%, toward the end of the year.

A Reuters poll from late last week found just over half of economists expecting the Bank to reduce rates to 5% in August; 43% thought a cut could come in June.

However, today’s 2.3% inflation figure was slightly higher than the 2.1% expected. This - coupled with the general election announcemnet - could spur traders to moderate their bets on a June rate cut.

…and mortgages?

Standard variable rates and existing tracker deals will likely only change when the Bank Rate moves. But the pricing of new fixed rates is very much influenced by movements in money markets.

Mortgage rates had been on the rise as rate cut hopes eased in the first few months of the year. But renewed hope of cuts has spurred some lenders to cut rates on new two, five and 10-year fixed rate mortgages. Last week, Barclays reduced its five-year fixed rate for a 40% deposit mortgage from 4.47% to 4.34%. HSBC is expected to act this week and other lenders may follow suit.

Should I worry about cash savings rates?

Understandably, cash savings have been popular over the past year. Now, in particular, there is a sweet spot where it is possible to achieve ‘real returns’ (returns once inflation is taken into account). For example, NS&I Premium Bonds pay 4.4% (the average interest payout in prizes) when inflation is only 2.1%. This indicates a real return of 2.3%.

However, interest rates on Premium Bonds and other savings products will come down if the Bank Rate falls. And they may even before that, in the same way that fixed mortgage rate pricing shifts with market expectations. Premium Bonds were already cut from 4.65% this 4.4% in March.

How does all this affect my investments?

Understandably, investors on our platform have been switching into cash funds. The Fidelity Cash Fund was no.3 in the top-selling ISA funds of 2023 and has remained in the top ten during 2024. It currently offers a distribution yield of 5.21%. Please note this is not guaranteed, if the bank rate falls, so will the income paid on these money market funds.

Something else to consider is the impact that inflation and interest rates have on stock markets.

Received wisdom suggests stock markets offer the best protection from inflation. Company revenues benefit from putting up prices, so the theory goes. That makes sense when inflation is manageable, but soaring inflation points to turbulence and that unnerves equity investors.

Research by asset manager Schroders offers some evidence in this regard. It showed that in the 50 years to 2023, US shares outperformed inflation 90% of the time when inflation was low (below 3%) and rising. But when inflation was above 3% there was only a 50/50 chance of beating inflation.

It is also worth considering another factor. Rising interest rates tend to hurt growth stocks due to their high valuations and low dividend payments. Investors are happy to pay expensive prices for these stocks because of their future promise of bigger profits. But when rates are high, the appeal of jam today over jam tomorrow grows stronger. Higher borrowing costs can also curb reinvestment into innovation and curb growth prospects.

We saw this impact in 2023. Rising rates in the first half of the year put growth stocks on the backfoot, and the broader market, but hopes of cuts in 2024 spurred a rally from October onwards.

We explain more here on investing styles and point to some relevant funds from our Select 50.

It is also worth noting, the strong rally going on in the UK. For more on this, try these articles:

Also of note in the rates and inflation debate is the direction of gold. The precious metal’s performance has been helped by growing hopes of interest rate cuts, which reduce the opportunity cost of holding gold. It’s also had a boost from ongoing geopolitical uncertainty, which causes many investors to hold gold for its safe-haven qualities. Read more: Gold miners vs Gold ETF: which has done best? (fidelity.co.uk)

What does it mean for your Fidelity cash rate?

If you have money sitting on our platform, you will earn a rate of 3.6% on any money not invested in an ISA and 3.7% on a SIPP. These rates have been increased steadily and would be reviewed when the Bank Rate begins to fall.

Other large platforms pay less, according to analysis from the independent Moneytothemasses website.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. The value of shares in a money market fund may be adversely affected by insolvency or other financial difficulties affecting any institution in which the fund's cash has been deposited. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.

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Nick Sudbury

Nick Sudbury

Investment writer


Ed Monk

Ed Monk

Fidelity International


Ed Monk

Ed Monk

Fidelity International