Falling inflation could be bad news for savers. Here’s what you need to know

According to the Office for National Statistics, inflation stood at 4.6% in October 2023, less than half the level it stood at 12 months earlier. When inflation hit 11.1% in October 2022, it was the highest level for more than 40 years, so the fact it’s dropped so significantly is likely to be welcome by most households.

That said, lower levels of inflation may not be all good news. As interest rates typically fall when inflation does, the recent downward trend may mean that the growth potential for cash savings could fall in the not-too-distant future.

Read on to discover why this is, and why investing your cash might be the shrewder option if you want to expose your wealth to potential growth over the long term. First though, let’s take a closer look at how inflation works and why it influences interest rates.

Inflation measures the rising cost of living over time

Inflation is the increasing price of goods and services, which has the potential to affect everything from your utility bills to your weekly shop. Over time inflation devalues your money in real terms, which means that £100 is likely to buy you more today than it will in the future.

To demonstrate this you may want to consider the Bank of England’s (BoE) inflation calculator, which reveals that you’d have needed £174 in October 2023 to have the same spending power as £100 in October 2003. This means that your money had to grow by nearly 75% just to keep pace with the rising cost of living.

While low levels of inflation are seen as the sign of a healthy economy, if it starts to rise too high, it can become damaging to the national economy. One reason for this is that it can push up the price of raw materials, which then increases the cost of production and reduces the profits made by businesses.

This in turn stops growth, which can have a negative effect on the nation’s economy.

Raising interest rates helps to tackle one of inflation’s biggest drivers

In the past, interest rates have been used to bring inflation down when it starts to rise, as doing so tackles one of the biggest drivers of inflation: consumer demand. A key reason for this is that higher rates mean that the cost of repayments for loans – and in particular, mortgages – increases, which then reduces the disposable income of millions of households.

In addition to this, higher interest rates encourage people to save and not spend. Both of these mean that people spend less, which in turn reduces consumer demand. As a result, interest rates have historically tended to rise when inflation increases, and drop when inflation falls.

Despite this, in November the BoE kept its interest rate at 5.25% even though inflation had dropped more quickly than expected. It was the second time in a row England’s central bank had decided to do so, due to fears that reducing it could prompt consumer spending and an upturn in inflation.

Interest rates could start to fall in 2024

While on the face of it the BoE’s decision may make sense, high interest rates are economically unsustainable. One reason for this is that the downturn in consumer spending can damage the nation’s economy and can even trigger a recession.

This is why governments tend to reduce interest rates when inflation falls.

So you won’t be surprised to learn that the BoE’s decision to retain its interest rate at 5.25% has prompted fears that it could be harming the UK economy. According to the BBC those fears may be justified, as it reported that Britain’s economy stagnated between July to September 2023.

Furthermore, in November, the BBC also revealed that UK economic growth was likely to be much slower than expected. Small wonder then, that in November 2023, The Times revealed that many analysts believe that interest rates could start to fall by mid-2024.

Investing your cash may expose it to greater growth potential

While you’re likely to welcome lower interest rates if you have a mortgage, you may not be quite as happy for them to fall if you have savings. Lower interest rates mean that the growth potential of your cash savings will reduce, which could devalue your wealth over the long term.

There is good news though, as historically the stock market has tended to outperform cash savings over the longer term, which means that investing might be something you want to consider. According to an article in This is Money, the 2023 Barclays Equity Gilt Study found that shares provided a real average annual return of 2.9% during the 20 years leading up to 2022. This compares to cash’s -1.1%.

The study, which tracked the nominal performance of £100 invested in cash, bonds or shares between 1899 and 2022, also revealed that if you had held shares for five years during the period, they would have outperformed cash in 90 of the 124-years.

If you had held stocks for 10 years, this increased to 103 years. As you can see, investing your money might be a more effective way to expose your cash to potential growth over the long term.

That said, always remember that past performance is no guarantee of future performance.

Get in touch

If you would like to discuss whether investing could help to boost your wealth’s growth potential, and whether it’s right for you, please call us on 01527 577775 or speak to one of our advisers, as we’d be happy to help.

Friday 15 December 2023