Rising interest rates, inflation and a falling pound – what it means for you

Yesterday, the Bank of England (BoE) raised the base interest rate by 0.25% to 1.25%.

The idea is as rates move higher, people should save more, borrow less and demand for goods will fall, helping bring down the eye-watering prices we’re currently seeing.

However, there’s a lot more to it than that.

A tough balancing act

Inflation risks being a slow poison for the economy, so the BoE is trying to take an antidote now by raising interest rates. However, it can only take a small dose at a time given the ailing nature of the economy.

It’s not following the prescription written by the US Federal Reserve of the more potent medicine of a steeper hike due to fears a deep recession could follow. The US central bank hiked rates by 0.75% at the last meeting, more than it had initially planned given the worries of spiralling prices.

But there are worries given inflation is expected to soar to 11%, the BoE is still going to be seriously behind the curve in attempts to bring it down.

There’s dissent around the table with the policymakers charged with administering the bitter pill for the economy to swallow. Three of the nine members wanted to see a steeper 0.5% rise.

Indications from the Bank suggest a more concentrated dose might well follow in the months to come, especially if these red-hot prices show no sign of easing.

There are also worries that even with the Bank’s intervention, prices might not come down as quickly as we want. A chunk of inflationary pressures have been caused by the war in Ukraine and are hitting essential products like fuel and bread. These won’t be easy to bring down.

The impact on the economy and stock market

The pound fell back further against the dollar to $1.20 as the Bank put out a rather bleak assessment of the prospects for the UK. A weaker pound could result in inflation lingering for longer. That’s because a weaker pound means the prices of imported goods are more expensive.

The UK stock market fell after the rate announcement. This reflected worries about what impact spiralling prices and a shrinking economy will have for companies and consumers. There are expectations spending will be reined in by businesses as they face higher costs and as the downturn deepens.

There are also concerns that shoppers will tighten the purse strings, as the cost-of-living squeeze intensifies. After the big Jubilee blow-out, it seems shoppers are reining in their spending, especially for big ticket items which aren’t essential.

If demand is already slowing, it could mean the Bank keeps on its more cautious path in the future. But it will need to see inflation coming down significantly from its red-hot levels before it can step off the pedal of rate rises.

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What it means for mortgages

Anyone on a variable-rate mortgage will be braced for impact again, as a fifth rise in six months kicks in. If you’re one of the 1.1 million people on a standard variable-rate mortgage, or one of the 850,000 with a tracker, it’s going to hurt.

Three quarters of mortgage holders are protected by a fixed-rate deal, so the rises will take a while to filter through. However, when their mortgage expires, they’re in for a nasty shock. The current average two-year fixed rate deal is 3.25%, up 0.92 percentage points from November. And the average five-year fixed rate mortgage is currently 3.37%, up 0.75 percentage points.

Not all mortgages are rising as quickly as the Bank of England base rate though. That’s because the big banks are still sitting on piles of lockdown savings that they can afford to fund cheaper deals. So for the dedicated mortgage hunter, there are still some affordable mortgages around.

Even among the banks hiking rates, the threat of a recession further down the line means rate expectations are lower when you look a few years down the track. It means banks are expecting rates to rise, then fall, so they’re offering plenty of cheap five-year mortgages. As a result, the gap between the rates on two-and five-year fixes has narrowed significantly. It’s worth considering fixing for longer if you want to have more certainty over your outgoings in the years to come.

If you’re on a variable rate, you might want to fix sooner rather than later. With rates set to keep rising this year, the longer you leave it, the more you’ll pay.

If you have a fixed-rate mortgage with six months or less left on your current deal, you could consider applying for a remortgage rate now. That way, you can lock in a deal in case rates rise again. If you have longer until your fix comes to an end, there’s time to plan for how you’ll cover the extra costs.

Ideally, you’ll be able to track down costs to cut elsewhere in your budget, to free up more cash for your mortgage. You could even do that now and overpay on your mortgage, to limit the impact of future rate rises.

If you’ve cut every cost possible, when the time comes you might be able to extend your mortgage, so your monthly payments are still manageable. However, this will mean paying more interest over a longer period, so it comes at a cost.

What next?

There hasn’t been much good news since the May forecast. The Bank expects inflation to be even higher later on this year, so the horrible squeeze on all our finances is here to stay. Much of this is down to another rise in the energy price cap – which it now expects to be around 40%.

At the same time, another set of weaker economic data means the Bank now expects growth to drop 0.3% between April and June – so we’ll see a shrinking economy far earlier than it expected in May – when the first falls were expected at the end of the year.

It means we’re set to enter stagflation – where we get higher inflation alongside a shrinking economy. This only makes the Bank’s task of raising rates, while keeping a close eye on the health of the economy, even tougher.

How should investors react?

The market is now pricing in a rate rise to 2.9% at the end of the year and to 3.3% in 2023. While this might be a bit punchy, it’s a strong indication of the direction of travel.

We can’t be certain how markets will react, or if they’ll react rationally. It’s important to keep some key investing principles at front of mind, like holding a diversified portfolio and thinking long term.

Having a diversified portfolio and spreading your money allows you to prepare when you can’t predict.

By investing in different types of companies, types of investments – like shares, bonds, and property – different parts of the world, or investment styles, your portfolio will be well equipped.

And then when your investments do go up and down in value, provided you’ve spread them smartly, you won’t have to play guessing games or make rash decisions when things happen.

This isn’t personal advice. If you’re not sure what’s right for your circumstances, ask for financial advice. Remember all investments and any income they produce can fall as well as rise in value, so you could get back less than you invest.

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