Bad news for savers – positive real interest rates are a long way off

Gordon Brown as chancellor of the Exchequer © Getty Images
UK inflation was reduced when Gordon Brown adopted CPI instead of RPIX

Today, at 12 noon, the Bank of England will make some noises about interest rates.

It won’t raise them, of course.

Instead, the market’s focus will be on exactly how many dissidents on the Monetary Policy Committee think that having a 0.25% interest rate at a time of full employment and soaring credit levels is starting to look like a foolish idea.

Today’s outcome will swing sterling about one way or the other – two votes or fewer for a raise will probably weaken it, three or more will strengthen it.

But unfortunately, none of that will solve the problem of how to get a decent return on your savings in a world where the central bank hates you…

How British inflation was permanently reduced by the EU

Once upon a time, the Bank of England had an official inflation target of 2.5%. This was based on a measure known as RPIX – the retail price index (RPI) excluding (hence the “X”) mortgage interest payments.

Why do you exclude mortgage costs? Well, the whole point of having an inflation target is so that the Bank can see when the economy is overheating, and raise interest rates to hold it back.

But raising interest rates also pushes mortgage costs go up (indeed, raising the cost of borrowing is the whole point). That’s why the target inflation rate leaves it out. Hence RPIX, rather than RPI.

In 2003, that changed. Under then-chancellor Gordon Brown, we moved from RPIX to the Consumer Prices Index (CPI). There were a couple of reasons put forward for doing this.

One of them – slightly ironically, it feels today – was all about convergence with Europe. The EU’s statistics body, Eurostat, had introduced a harmonised measure of inflation for all EU countries, and all EU members had to develop their own version. Ours was CPI (it was called the “Harmonised Index of Consumer Prices (HICP)” when it was first published in 1997).

At the time, Brown was still teasing Tony Blair with the idea that Britain might one day join the euro, and that his dreams of becoming President of the United States of Europe would one day come true. Adopting an inflation index that could be compared directly with other European nations (as part of Brown’s elaborate “five tests” charade) enabled Brown to keep Blair off his back.

Another was that statisticians largely consider CPI to be a superior measure. There’s a whole technical conversation about “arithmetic vs geometric means” that you can Google if you really want to know the gory details.

One side effect of this is that CPI is structurally lower than RPIX. It is now and it always has been. That’s why the Bank’s inflation target is now 2% rather than 2.5%.

It’s also why – at the time – the government assured everyone that RPI would continue to be used as the basis for calculating benefits, pensions, tax allowances, and index-linked gilts.

Of course, as we all know, no radioactive isotope yet discovered has a shorter half-life than a government promise. Defined benefit pension schemes are, where at all legally possible, now switching over to CPI indexing by the fistful. Meanwhile, there’s constant talk of future gilts being indexed to CPI rather than RPI.

And judging by yesterday’s wage data, nobody gets an RPI-linked wage increase these days.

A grim prospect for savers

Trawling through the old statistics is a fascinating process in itself. It’s a valuable reminder that the things you take for granted in one era (such as the idea that base rates will always remain higher than inflation), can change pretty much overnight.

It also puts the recent asset-price inflation into some perspective. When you realise that, a decade ago, “real” interest rates (as measured by CPI) were sitting at almost 4%, and that they’ve now fallen to negative 2.65% (and that’s ignoring all the quantitive easing) – well, the real question is, why aren’t asset prices even higher?

But one thing’s for sure, and there’s no easy answer to it – if you’re a saver, this is all bad news. The Bank might show some signs of stirring later today, but even a surprise quarter-point rate rise (which almost certainly won’t happen) would still leave real rates well below 0%.

It’s a horrible dilemma. And one that you’ve deliberately been pushed into facing. This is, as they say, a feature rather than a bug of low interest-rate policy.

You can stick your money in a cash account (or short-term government bonds) and watch it get slowly eroded away by inflation. There is no cash account out there that pays 4.1%, or even 2.9% a year.

The alternative is to invest it, at a time when finding an asset class that’s even reasonably priced, let alone cheap, feels almost impossible. Of course, if you plan on needing that money within the next five years you have to really think very hard before taking any risk with it at all.

And don’t expect this to end any time soon. This is the repression bit of “financial repression”. The best way to get rid of a load of debt is to inflate it away. It’s taking a lot longer than the world’s central bankers and politicians might have hoped, but we’re getting there.

With the public sector agitating over pay rises and Jeremy Corbyn waiting in the wings, it may not be long before “real” interest rates fall a lot further – even if the Bank does start to hike nominal rates.

As I said, there’s nowhere “safe” that you can keep your money to help you circumvent this. And in terms of investments (as we’ve been emphasising a lot recently), when stocks and bonds are as expensive as they are now, it seems a mistake to feel forced into owning more of them than you feel comfortable with.

But do make sure that you own a bit of gold as part of your portfolio. I know I say it a lot, but if central banks can’t get inflation going by themselves, the politicians will be only too happy to help out – and as my colleague Merryn Somerset Webb pointed out in a recent issue of MoneyWeek magazine, they could well drag us back to the 1970s in the process.

  • Tawse

    As an aside, the jump in NEXT this morning seems crazy. Sales lower but the shares jump about 12% because the boss says things are looking better and that they are going to buy back more shares?

    Dunelm came out yesterday with poor sales and said trading conditions were bad – up almost 7%. M&S is up seemingly on no news other than Waitrose sales are down.

    Thank goodness John Lewis is not listed – saying that its sales are down by half probably would have seen its SP double this morning.

  • Charlie D

    I’ve got about £1.5 million in savings accounts paying derisory interest. I vote Conservative, but if the current authorities confiscated the bulk of my savings, I would vote Labour, since I’d have nothing to lose and would be reliant on the state.

  • Triple H

    John, I get it you and MW have a certain view on interest rates (the higher the better in short). I disagree but what I really want you to comment on is why is inflation loved by governments and what your proposals are to tackle it? Given that inflation is the real fear savers have when they long for high interest rates, I think you should pen something on this.