Inflation eases to 10.5%: What this means for your personal finances

Alice Haine, Personal Finance Analyst at Bestinvest, the DIY investment platform and coaching service, comments:

“UK inflation may have eased for the second consecutive month, softening to 10.5% in the 12 months to December from 10.7% in November, but this won’t offer instant relief for consumers whose disposable incomes are being heavily dented by falling real incomes, high borrowing costs and who are staring at the biggest tax burden since the 1940s.

“At 10.5%, inflation remains almost double the 5.4% recorded in December 2021 and more than five times the Bank of England’s target rate of 2% - a clear reflection of just how squeezed household incomes have become over the past year.

“December’s easing inflation reading was largely driven by falling fuel prices, with the decline offset by high food and non-alcoholic beverage prices, which rose by a staggering 16.9% on the year to December, up from 16.5% in November - the 17^th consecutive monthly increase and the highest rate since September 1977.

“A retreating headline inflation rate will certainly offer hope to consumers that the financial squeeze is starting to ease - strengthening the sentiment that inflation has passed its peak, after hitting a 41-year high of 11.1% in October and will fall rapidly over the course of this year.

“While the war in Ukraine was the biggest driver of the runaway prices of 2022, due to the sharp increase in wholesale energy costs, oil and gas prices have since eased from their highs helped by the milder than usual winter.

“However, consumers cannot breathe a full sigh of relief just yet. Pay growth gathered pace in the three months to November with wages excluding bonuses rising by an annual 6.4% - the biggest increase since records began in 2001 not counting the jumps seen during the pandemic.

“Meanwhile, the low unemployment figure of 3.7% – partly a reflection of the continuing shortage of workers as economic inactivity remains above pre-pandemic levels due to early retirement and high long-term sickness rates - still poses a risk to inflation as companies do their best to retain staff with bumper pay rises.

“Ultimately, high inflation is largely a result of global challenges such as supply chain constraints and geopolitical tensions and there are no guarantees of what lies ahead. However, with the BoE likely to continue its rate hiking cycle despite recession fears, mortgage costs significantly higher than a year ago and households already slashing expenditure to keep costs down, inflation is likely to continue easing from here.”

“The headline inflation rate may be on the retreat, but double-digit price rises will still deliver a blow to disposable incomes. High inflation has a corrosive effect on the real value of cash as it erodes purchasing power and eats into savings, forcing households to make spending cutbacks that will of course have consequences for many businesses too.

“Throw in higher borrowing costs, a rising tax burden and falling real wages - a driver of the intensifying industrial action - and most households won’t be feeling the benefits of an easing inflation rate just yet. Instead, careful budgeting will remain a priority for now as they strive to keep everyday costs in line.

“The other big threat is the risk of job loss. Unemployment levels have been incredibly low in recent times but as the economy flirts with recession, at some point companies will have to make difficult decisions around their staffing levels.

“Households that haven’t faced up to the reality of their dwindling purchasing power yet would be wise to examine their bank and credit card statements now to identify where they can cut back their own expenditure. With lockdown savings all but used up, turning to credit will become the only other option for some as high living costs persist – something already evident by the sharp rise in credit card borrowing in November.

“With property prices on the wane, and mortgage costs set to jump for 1.4 million households this year, taking a microscope to your spending will become key to ensure the essentials of life – such as housing, food and energy – can still be afforded and luxuries are carefully prioritised from what it is left.

“Living within your means, drawing up a solid budget you can stick to and doing an audit of your regular payments and subscriptions will all help to identify overspending patterns to ensure finances can stay robust in the long term as well as the short term.”

“With interest rates currently at 3.5% and expected to jump again at the Bank of England’s next monetary policy meeting in February as the battle against price and wage growth persists, mortgage rates are perilously high when you compare them to the past decade.

“However, they have eased from their October highs when the market was still reeling from the effects of disastrous mini budget. The average two- and -five-year fixes now sit comfortably below the 6% mark* and while interest rates are still expected to rise to 4.5% - that is a lower level than previously feared.

“With lenders now actively slashing the cost of deals as they compete for new business, the hope is that rates will continue to drop from here. Borrowers that have already locked in a new product in recent weeks for an upcoming mortgage should contact their broker or provider to negotiate a fresh deal.

“Borrowers must also remember that with inflation still in the double digits, affordability will remain an issue both for first-time buyers and those looking to remortgage. A higher cost of living hurts disposable incomes, something lenders examine carefully when assessing a borrower’s creditworthiness. This will have a knock-on effect on house prices. It means first-time buyers may not be able to borrow as much as they could a year ago, while those looking to refinance at a time when house prices are expected to slide may find their loan-to-income ratio is adversely affected.

“With 1.4 million fixed rate mortgage deals set to expire this year, many homeowners will face much higher mortgage repayments when they sign up for a new offer – even with falling rates - unless they have been able to overpay in the run-up to the end of their deal. The BoE estimates average repayment hikes of £250 per month when homeowners switch onto a new product - though for some the increase could be much larger depending on how low their previous fixed rate was.

“The only silver lining is that with more mortgage products available now than during the mini-budget chaos when many providers pulled products and lenders competing more aggressively for new business, mortgage rates are unlikely to jump up dramatically as interest rate rises have already been priced in.”

“Savings rates have risen significantly in recent months, reflecting interest rate rises, but with inflation still high, any real return will still be deeply negative.

“Double-digit inflation has a devastating effect on people’s savings pots, as it erodes the value of that money. Even with the top easy-access accounts now at 2.9%, fixed accounts at 4.56% and regular savings at 7%, the real return will still be negative.

“However, with the BoE expecting inflation to halve by this time next year, locking in the best fixed rate possible could pay off over the longer term when the gap between pay growth and inflation eventually narrows.

“This will be particularly pertinent for those with money languishing in accounts paying 0.1% or worse 0% – a hangover from the era of ultra-low interest rates. Some consumers have fallen out of the habit of moving their money into an account offering a better deal so checking the interest rate on all your savings accounts would be wise.

“Even moving your cash savings to an account with the same lender can pay off as banks and building societies typically offer better rates on new accounts. Ultimately, making your money work harder in a higher-interest account is a better option, even with high inflation, than leaving it in an account that pays little or no interest at all.”

“High inflation is always a blow for retirees looking to maintain their purchasing power, particularly those solely dependent on the state pension who have a fixed amount to spend each month. The good news is that state pension payments will go up by 10.1% from April, hopefully coinciding with a period when the pace of price rises eases further.

“For now, however, retirees on lower or fixed incomes will find their money does not stretch as far, and some pension savers may be tempted to reduce or stop pension contributions altogether as they prioritise rising living costs instead – leaving some at risk of a pension shortfall in their retirement years.

“However, money directed towards pensions and investments can counteract the damaging effects of inflation over time, particularly for young savers, thanks to the compounding effect over the long term and generous state tax reliefs.

“For pension savers looking to boost their retirement income, now would be a good time to increase pension contributions. That’s because any money invested in a pension not only benefits from the beauty of compounding over the long term, but also protects against income tax (which is on the rise thanks to frozen tax thresholds) because tax relief is applied to pension contributions at their marginal rate of income tax.

“While basic rate taxpayers get 20% added to their pot with each contribution, those on the higher 40% tax rate get a further 20% in tax relief, while additional rate taxpayers receive a further 25% back. For every £1,000 gross contribution paid into a pension by a 40% taxpayer, the net cost is just £600 giving their pot a generous £400 bump-up in tax relief.

“Those on the brink of retirement who are fearful that high inflation will erode any income they take from their pension pots could also consider buying an escalating annuity – a type of contract that offers a guaranteed income in retirement, which increases over time to keep up with inflation.

“Annuities have been deeply out of favour for many years, due to the low rates available amid the era of cheap money, with most retirees choosing to stay invested and draw an income from their pension pot instead. However, gilt yields rose significantly last year which has also driven up annuity rates. For some retirees, a blended approach towards retirement of both purchasing an annuity to cover basic costs, alongside drawdown on the rest of their pension pot can be the right one.”

* According to Moneyfacts