The last few years have been tough, with the cost of your weekly shops, energy bills, and mortgage repayments likely to have sharply increased.
In the wake of the pandemic, the war in Ukraine, and an under-supplied workforce, inflation surged to a 41-year high of 11.1% in October 2022. This led to a cost of living crisis that likely squeezed your budget and may still be pinching your wallet today.
So, there was relief in many quarters when data from the Office for National Statistics (ONS) revealed that inflation had finally returned to the Bank of England’s (BoE) target rate of 2% in May.
The BoE has so far decided to maintain the base rate at 5.25% – the highest in 15 years – to ensure inflation remains stable, though experts forecast that cuts are imminent.
So, with inflation back down to the target rate and currently below the base rate, what could it mean for your savings, mortgage, pension, and investments?
Read on to discover five ways the return to 2% inflation could affect your finances.
1. Your expenses won’t necessarily go down
Lower inflation does not typically mean prices will fall, but that prices will continue to increase at a slower pace.
With inflation still at 2%, your weekly bills and expenses are unlikely to decrease, nor will there likely be a reversal of the price hikes of recent years.
So, while lower inflation offers some welcome relief, it may not immediately alleviate the pressure on your household budget.
2. Your savings returns could beat inflation
High inflation is the number one enemy of cash savings, as it can eat away at the real value of any money you hold in cash accounts.
Interest rates are often set below inflation even when inflation is low, meaning cash savings can lose their real value over time.
As you can see in the graph below, until the end of 2023, inflation had been consistently higher than the base rate since the beginning of 2018.
Source: Statista
However, with inflation at 2% and the base rate at 5.25%, many savings accounts currently offer interest rates higher than inflation.
Although this is unlikely to last as the BoE is expected to begin reducing the base rate soon, fixed-rate savings accounts could be a good option for delivering returns on your cash savings.
3. Your mortgage rate could come down
Inflation indirectly influences mortgage rates, as it is the base rate that affects the interest charged on mortgages and the base rate is often set relative to inflation.
The graph below shows the relationship between the base rate and the average rates of different mortgage types.
Source: Rothschild & Co
If you have a tracker- or variable-rate mortgage, when interest rates rise or fall, you will usually see an immediate change in your repayments.
Yet, the BBC reports that more than 8 in 10 mortgages are fixed rates. If you are on a fixed rate, your monthly repayments won’t instantly change, but lower rates mean you may benefit from a cheaper deal when your fixed rate ends.
So, though lower inflation may not directly influence your mortgage rates, any future cuts to the base rate could benefit your mortgage repayments in the coming months, though you may have to wait longer if you have a fixed rate.
4. Your investments could perform better in real terms
Like cash savings, high inflation can cause your investments to lose their real value – though the market generally has a better chance of outperforming inflation, particularly over longer time horizons.
Research by Schroders on the US market found that when inflation was below 3%, equities outperformed inflation 90% of the time. But when inflation was above 3%, equities had roughly a 50% chance of beating inflation, about the same as a coin toss.
While the market could still be one of the best places to store your wealth during periods of high inflation, lower inflation rates mean your investments are likely to perform better in real terms.
5. Your pension is more likely to retain its real value
The influence of inflation on pensions depends on the pension type, but lower inflation is usually good news.
The triple lock guarantee protects the State Pension from inflation by ensuring it rises each year in line with the highest of inflation, the average wage increase, or 2.5%.
Defined contribution (DC) and defined benefit (DB) pensions are more susceptible to inflation.
DB schemes vary depending on your provider and employer, but they often rise in line with inflation up to a certain cap, usually between 3% and 5%. So, during periods of high inflation, DB pensions may lose some of their real value as your annual rise may not keep up with the increase in the cost of living.
With a DC pension, your provider invests your contributions with the aim of achieving market returns that surpass inflation. Over longer periods, the market generally outperforms inflation, and the probability of this outcome increases the longer you stay invested, though it is not always guaranteed.
So, a return to 2% inflation will likely be welcome news if you have a DB or DC pension.
Get in touch
To find out how you can make the most out of the recent fall in inflation, get in touch.
Email us at hello@vwmwealth.com or call us on 0141 229 4004.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
A pension is a long-term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Your home may be repossessed if you do not keep up repayments on a mortgage or other loans secured on it.
