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Inflation, Interest Rate and you; Why we need to get a grip on our personal finances now.

The fact that three out of eight members of the monetary policy committee voted in favour of rate rise should worry anyone with large debt or at least should be a warning sign

 

The inflation rate in Britain edged close to 3% this month, the target it was expected to reach by the end of the year according to forecast, meaning inflation rate is rising faster than it was forecasted and definitely higher than Bank of England targets of 2%.

At the same time, Bank of England’s Monetary Policy Committee (MPC) was close to a deadlock in their vote to raise or keep the interest rate at its current level of 0.25% which was set in August 2016. A 50% drop from its previous lows of 0.5%.

Bank of England Historical Interest Rate Data

Often, these economic pointers do not mean much to people, but their effect does impact people.

Take inflation for example, in layman’s term, it means, what you can buy with a £100 when the inflation rate was 1%, you would need more money to buy the same thing when inflation rate rise to 3%, this coupled with the fact that the income of people is not rising means we are getting poorer because of fall in the purchasing value of money.

The cause of inflation is an irony; it is primarily caused by high demands or when demand exceeds supply. So, the more we buy, the more the incentive for the manufacturer and everyone in the production line up to the retailer to bump up the price. Hence, if we take aside all the other minutes or intricate causes, inflation can be traced to greed.

It is an irony because, the consumer, whose income is not rising is paying the price for the greed. The government need the consumer to continue spending because that is the way the economy is kept alive. If we all cool our spending and reduce our demands, inflation will drop but government do not want us to stop spending. It is not in their interest for us to keep our money, so they have to actively influence our behaviour.

Although it is not a one-way street, it works for us as well, if we cool our demand long enough, it will have a direct impact on the ability of businesses to retain staff, jobs would be affected and growths choked off.

Wait, our income is stagnating, inflation is going up which probably means demand for goods and services are going up, how is this possible? The answer is cheap credit! Which bring us to the topic of interest rate.

One of the ways government can create artificial demand or influence our behaviour at the economic level is to keep the interest rate super low. It was already low at 0.5%, a level it was on for eight years before it was further reduced to its current level of 0.25% in August 2016.

 

uk household

Table is Courtesy BOE data on UK household indebtedness

 

 

Access to cheap credit continues to fuel demands.

“A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can also affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased.” (excerpt from Bank of England page on how monetary policy works).

Bank of England on low-Interest Rate

The take home from this statement is that low-interest rate makes saving less attractive and borrowing more attractive. (That is a practical and common knowledge, so it’s not a news)

Another take home is that, the poor borrow to spend either on unavoidable essentials (necessary expenditure) or on luxury items (luxury because they are not necessary) while the rich borrow to invest either in an active or passive way. This can maybe explain, in part the widening gap between the poor and the rich. (Although not only the reason)

According to the ONS, total unsecured debt hit an all-time high of £349bn as at September 2016, this translates to about £13200 per household, prior to the 2008 financial crisis, it was £13300, and this is predicted to continue to rise. (Analysis of the ONS figure was conducted by the Trade Union Congress).

Let us put this in perspective, to clear a debt of £13200, you would need a substantial amount of money left after you have paid all your essentials; Mortgage/Rent, Council Tax, Gas and Electricity and allocate money for your direct debits as well as feeding and then pay off part of the debt.

To pay a debt of £13200, assuming you are not taking on additional debt, it will take 6 years at a typical personal loan interest rate of 3% APR

Loan repayment cal

This is money loan-repayment online calculator

However, from the conversation I have with people, what I get is that their primary income does not cover the essentials, so they have had to rely on credit cards, which means not only will they not be able to clear the existing debt, they will incur more! Now, try to imagine the impact of interest rate rise?

It is an alarming prospect, yet it cannot remain low forever.

The fact that three out of eight members of the monetary policy committee voted in favour of rate rise should worry anyone with large debt or at least should be a warning sign. The outcome of the next meeting to decide the rate is uncertain, although many analysts are of the view that this rate will likely remain at the current level.

In any case, either high or low-interest rate, it is incumbent on us all to take a second look at our spending habit and decide what are absolute essentials and non-essentials and take a step to begin to address our debt level.

 

 

 

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