Interest rates dictate the cost of borrowing money, or the reward for saving.
One of the main influences on interest rates is the Bank of England’s “Base Rate”. This influences many other interest rates in the economy, including what you might pay for a loan/mortgage or receive on a savings account.
On Thursday 4th August, the Bank of England raised the base rate by 0.5% to 1.75%. This is the highest the base rate has been since 2008, although still low by historic standards.
This is to stop prices rising so fast and bring down the rate of inflation. Parliament tasks the Bank of England with keeping the rate of inflation at 2% per annum.
What is inflation and why is it so high?
Inflation is the measure of how much the cost of goods and services go up over time. Inflation is currently around 10% per annum, with some predicting that it could increase to 15% by the end of the year.
Higher energy prices are one of the main causes of high inflation. Russia’s invasion of Ukraine has led to large increases in the price of gas, which has doubled since May. Higher prices for the goods we buy from abroad have also played a role. During the Covid pandemic, people began to buy more goods. However, suppliers had problems obtaining sufficient stock to meet customer demand. This has led to higher prices, particularly for goods imported from abroad.
There is also pressure on prices from developments in the UK. Businesses are charging more for their products and services because of the higher costs they face. In addition, there are more job vacancies than there are applicants and so employers are having to offer higher wages to attract employees.
How do higher interest rates help to bring down inflation?
Increasing interest rates makes borrowing money more expensive and encourages people to save. Therefore, people will spend less within the economy. This then reduces the demand for goods and services, slowing the rate at which prices are rising.
Impact and Outlook
Borrowers will find the cost of their loans/mortgages will increase over time with increasing interest rates, whilst savers will be rewarded with more generous interest rates on their savings.
Precisely where interest rates will go depends on what happens in the economy and the consequent actions from the Bank of England over the coming years. The quicker inflation comes under control, the less there will be a need for further increases in interest rates. The Bank of England review the position regularly, around every 6 weeks. Current expectations are that rates will continue to rise during the remainder of 2022.
A potential consequence of increasing interest rates is that it pushes the economy into recession. As household disposable income reduces, there is less discretionary spending and this reduces the size of the economy.
Whilst the economy may enter recession, there is a reasonable prospect it will be shallow by historic standards given the strength of the employment market. Once inflation comes down to more manageable levels, this should create a suitable environment for economic growth to return.
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Additional Reading
With the end of the tax year fast approaching (5th April), have you maximised your tax allowances? Here are a few areas to consider.
1. Pensions
Pay into your pension – receive tax-relief on contributions paid in up to 100% of your earnings (capped at the annual allowance of £60,000) or £3,600, whichever is greater. The below illustration shows the benefit of tax relief on contributions:
Source: Phoenix Wealth
Restore allowances – making pension contributions can restore a lost personal allowance or help avoid the child benefit tax charge.
Limited company – pension contributions from a limited company are an allowable business expense, therefore reducing the corporation tax bill.
Carry forward – unused annual allowance from the 3 previous tax years can be carried forward when making pension contributions.
Match your employer’s pension contribution – some employers will pay more into your workplace pension if you agree to increase your contributions too, known as ‘contribution matching’.
Children’s pension – a parent/legal guardian can open a pension for their children. Anyone can then contribute up to £2,880 net each tax year, which becomes £3,600 with tax relief.
State Pension boost – you need a complete national insurance (NI) record to qualify for the full State Pension. Any gaps that are unlikely to be filled from work (or qualifying benefits/care credits) can be covered by a voluntary NI contribution. You still have time to cover any gaps going back to 2006. However, from April 2025 you will only be able to go back 6 years. Check your State Pension forecast online: https://www.gov.uk/check-state-pension
2. Investments
ISA allowance – save up to £20,000 into an ISA each tax year. Any interest or investment returns are completely tax-free. You can hold a cash ISA, stocks and shares ISA or a mixture of both (but the total paid in cannot exceed £20,000 each tax year). This is ‘use it or lose it’, meaning you cannot carry forward any unused ISA allowance into the new tax year.
Junior ISA for under 18’s – save up to £9,000 each tax year into a Junior ISA for children, which they can access from 18.
Lifetime ISA – if you are over 18 but under 40, you may wish to consider a Lifetime ISA for a first-time property purchase, or retirement. Check out our earlier blog: https://beechwoodfs.co.uk/2023/06/16/lifetime-isa-a-25-government-bonus-towards-first-home-or-retirement/
Capital Gains Tax (CGT) exemption – this is the amount of gain you can realise each tax year before paying CGT. This year’s allowance is £6,000, which reduces to £3,000 from 6th April. This is a use it or lose it allowance. If you are married, you can do an interspousal transfer, meaning you can transfer investments to your spouse/civil partner so they can use their annual exemption also.
3. Tax Planning
Register losses – you have 4 years to register any capital losses with HMRC. These can then be carried forward indefinitely to reduce any future gains (after you have used your annual CGT exemption).
Marriage allowance – if your spouse does not use all their personal allowance, they can transfer up to £1,260 to you, provided you are a basic rate taxpayer. This can save income tax up to £252 in the tax year. Claims can be backdated up to 5 years.
Gifts – there are a number of annual gift allowances that you can use in trying to reduce the size of your estate and therefore potential inheritance tax (IHT) on death. These gifts are outside of your estate immediately, rather than having to wait 7 years. Each tax year you can gift away:
- £3,000 – if you don’t use the full £3,000 exemption, you can carry it forward for one year only.
- Up to £250 as many times as you like under the small gift’s allowance. Note this cannot be combined with any other gift allowance.
- Marriage – £5,000 to a child getting married and £2,500 to a grandchild getting married.
- Regular gifts from unspent excess income.
Please note that these are the rules under current legislation, which can change. This is for information only and does not constitute a personal recommendation. Please speak to one of the advisers at Beechwood to get the best advice for your circumstances.
Article By
Michelle Murphy
Independent Financial Adviser
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