Understanding inflation, the base rate, and GDP | Flagstone (2024)

Understanding economic factors can help you make more informed financial decisions to grow and protect your wealth. In this article, we explain some of the key economic elements that can influence the growth of your savings.

Table of contents

• What is inflation?

• How is inflation calculated?

• Why does the inflation rate matter for savers?

• What is the Bank of England base rate?

• How is the base rate decided?

• Why does the base rate matter to savers?

• What is GDP?

• How is GDP calculated?

• Why does GDP matter to savers?

What is inflation?

Inflation is one of the most talked about topics in financial news. The term ‘inflation’ refers to the increase in the price of goods and services in the UK. How quickly prices go up is called the inflation rate. When economists talk about inflation, they express it as a percentage change over a year. For example, if inflation in the UK is 3%, it means that, on average, prices are 3% higher than they were the same time last year.

High inflation means prices are increasing swiftly, which reduces purchasing power over time. So the money you have today doesn't buy as much as it used to. If wages don't keep up with these rising prices, people's standards of living can fall. Additionally, if the inflation rate rises too high, it can contribute to a recession.

Low inflation means prices are increasing slowly. It's beneficial for consumers because your money keeps its real value, meaning it goes further. But if inflation is too low (below the government's 2% target), it can mean there's not enough demand for goods and services. This isn't good for businesses, and can lead to job losses.

Maintaining a low and stable level of inflation creates a healthy economy. The government sets a yearly inflation target, which the Bank of England (BoE) is responsible for maintaining.

How is inflation calculated?

The Office for National Statistics (ONS) is responsible for checking how much prices have risen in the UK. They track the expenses of over 700 commonly bought items, ranging from basic necessities like food and transport costs, to larger purchases like cars and holidays. The total cost of this ‘basket’ of items reflects the overall change in prices. This is known as the Consumer Price Index (CPI).

To calculate the inflation rate, the ONS compares the current cost of the basket to what it cost a year ago. The change in price over that year tells us the inflation rate. The ONS run a large number of surveys to ensure the index accurately reflects what consumers are buying, and that the prices are correct.

Each month, the ONS shares the latest CPI data on their release calendar.

You can use the ONS’s inflation calculator to see how prices have changed over time.

Why does the inflation rate matter for savers?

The inflation rate is important for savers who are looking to grow their wealth. Here’s why it matters and how it can impact your saving strategy.

1. It influences the base rate

The BoE adjusts the base rate to control inflation, using the CPI (the ‘basket’ of goods we mentioned earlier) as a key indicator for measuring inflation. Higher inflation may prompt the BoE to raise the base rate - the single most important interest rate in the UK. This often leads to higher returns on savings accounts, as banks pass on the increased rates to savers.

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2. It affects retirement planning

Many retirees live on fixed incomes from pensions, annuities, or savings. Any increase in the cost of living due to inflation can reduce the purchasing power of your income over time. Understanding CPI trends can help you adjust your retirement savings strategy to stay financially secure later in life.

Certain pension plans offer cost-of-living adjustment, ensuring you’re protected against fluctuations in inflation. To minimise a drop in the real value of your pension pot, consider talking to a Financial Adviserwho can provide tailored advice based on the latest economic conditions.

3. It affects purchasing power

£1 is essentially worth less if, overall, prices for goods and services increase. Remember how much you were able to buy for £1 years ago – much more than you’re able to buy today. This is due to inflation. If the interest rate on your savings account is lower than the inflation rate, your money’s purchasing power decreases over time.

What is the Bank of England base rate?

The BoE base rate (also known as Bank Rate) is the main interest rate in the UK. It’s set by the Monetary Policy Committee (MPC) who collectively determine the base rate as part of their efforts to meet the government's inflation target.

It’s important because it sets the interest rate for commercial banks. This affects the rates that banks charge you for loans and the interest you earn on your savings.

To prevent prices rising too quickly, the BoE adjusts the base rate. When rates rise, borrowing becomes more expensive, so people tend to spend less and save more. This decline in spending can help slow down price increases.

How is the base rate decided?

The MPC consists of nine members, each with expertise in economics and monetary policy. At each meeting, the Governor of the BoE proposes a policy they believe will secure majority support from the MPC members, who then vote on it. Each member's vote is independent. In case of a tie, the Governor has the deciding vote.

The decision-making process happens every six weeks, and the MPC announces its decision publicly at noon on Thursdays.

You can view the dates for upcoming announcements on the BoE website.

Why does the base rate matter to savers?

Interest rates on savings accounts tend to be linked to the BoE base rate. When the base rate rises, banks often offer higher interest rates to attract customers. If you keep on top of the changing rates and secure competitive deals on high-interest savings accounts, you can maximise the returns on your money.

What is Gross Domestic Product?

Gross Domestic Product (GDP) measures the value of goods and services produced in a country over a period of time. It serves as an indicator of the size, growth, and overall health of the economy, allowing for comparisons with different economies at different points in time.

How is GDP calculated?

The ONS calculates GDP by meticulously gathering data from companies across the UK. It uses three primary methods:

1. the output approach – this sums up the total value of goods and services produced
2. the income approach – this sums up everyone's income within the country
3. the expenditure approach – this considers all the money spent

Using this data, the ONS produces the official GDP figure for the UK. This figure serves as an indicator of the country's economic health, guiding policymakers, businesses, and investors in their decision making.

The ONS provide updates on GDP numbers every month, with bigger updates each quarter.

Why does GDP matter to savers?

GDP growth plays a significant role in shaping the economic landscape and consequently affects savers in various ways.

1. GDP growth can influence the base rate

As mentioned, when the BoE raises the base rate during periods of economic growth, banks and financial institutions often pass on these higher rates to customers. As a result, you can benefit from higher interest rates on your savings accounts. When the base rate is high, it’s an opportune time to research high-interest savings accounts to find the best rates.

2. GDP growth can lead to inflation

When GDP is growing, it often leads to increased consumer spending and demand for goods and services. This heightened demand can push prices higher, leading to inflation. When this happens, it’s important to be mindful of the impact of inflation on your savings. Consider actively looking for savings accounts with high interest rates that help mitigate the effects of inflation and preserve the real value of your savings.

3. GDP growth creates a stronger job market and higher wages

During times of economic growth, businesses may be more inclined to hire additional workers and offer wage increases. Higher employment levels and wages can positively impact your cash savings, by providing you with more disposable income to save and invest.

Are you using interest rates to your advantage?

Take a look at your existing accounts. If your cash is sitting in a current account for convenience, you may not be seeing much in the way of returns. Make your money work harder by shopping around for savings accounts that offer more attractive interest rates.

At Flagstone, you get access to competitive and exclusive rates from 60+ banks. High-interest savings rates not only help your money grow but also enable you to tame inflation by ensuring you're earning the highest possible returns.

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Explore: the ultimate guide to growing and safeguarding your savings.

This article is not advice. If you would like to receive advice on your savings and investments, consider speaking to a Financial Adviser.