Fair Deal for Savings

Many older people are feeling poorer this year. Which is strange because the state pension rose by an inflation-busting £5 a week last April and there is another above-inflation increase of £3 a week promised for this April. While prices will probably rise between April 2000 and April 2002 by less than 4%, the pension will rise by nearly 12%. So why are people feeling poorer? It is quite simply because the income earned on their savings has been slashed by at least a third as interest rates have tumbled.

Over the last year the official interest rate set by the Bank of England has fallen from 6% to 4% - that is a cut of one third – and the rates on many savings accounts were cut by more than that. Many older people have savings they have carefully put aside over a lifetime to ease the difficulties of retirement. But with interest rates so low, even relatively large amounts of money in the bank are no longer able to bring in a decent income.

Suppose you are lucky – or careful – enough to have £50,000 in the bank. At the start of 2001 that could happily be earning 6.25% bringing in a healthy £3125 a year, nearly as much as the state pension. Today, you would be lucky to get 4%, £2000 a year, which is a cut in your income of more than £21 a week. Compared to that, the £3 a week pension rise this April, and £5 a week last, look puny. Anyone with around £20,000 or more in the bank will have seen the £8 a week total wiped out by falling interest rates. People with barely £8000 in the bank will have lost as much in falling interest rates as the £3 rise due in April. So hundreds of thousands of people over 60 have seen the extra state pension more than wiped out by cuts in the interest paid on their savings in the bank.

Although many economists think interest rates have now reached their lowest there is still a possibility they will be cut again. It is one of the principles of economics that when the demand for something goes up, so does its price. And as demand falls, the price is cut. The Government thinks the same is true of the whole economy. When interest rates are low, it is cheap to spend money – whether we borrow it or use our savings – so we shop more. As demand in the shops goes up, prices rise. Then if interest rates are raised, it becomes more expensive to shop – the cost of borrowing rises and if we spend out savings, it costs us more in lost interest. So we stay at home and inflation falls as the shops cut prices to try to tempt us back.

Since 1997, the Bank of England has had the job of raising and lowering interest rates to control inflation. But it is the Chancellor who tells the Bank what rate of inflation it should aim for. Five years ago when the present system began, Gordon Brown set that target at 2.5% a year. If inflation falls below that amount, the Bank cuts interest rates to encourage us to shop more. On the other hand, if inflation goes above 2.5%, then the Bank raises interest rates to discourage us from spending money.

One problem with this system is that it takes a long time to have any effect. Inflation does not change for about 18 months after interest rates are altered. So the Bank’s Monetary Policy Committee, which sets interest rates, has to predict what is going to happen and act a long way in advance. In 2001 the Bank cut interest rates seven times – from 6% in January to 4% in December. But instead of rising, inflation fell throughout the year, from nearly 3% at the start to around 1% at the end. Despite record spending in the shops over Christmas and record new car sales towards the end of the year, it may not be enough to push inflation up from its 38 year low. As long as it remains below the Government’s 2.5% target, the Bank will have no choice but to cut interest rates again, leaving people who have saved hard all their lives with even less money to live on.

The answer is as simple as it is obvious. The Government should reduce the inflation target it sets the Bank of England. There is no reason why 2.5% is the ‘natural’ rate of price rises. In the Victorian era, when Britain was the richest nation on Earth, prices actually fell for much of the century. If the Chancellor cut the target to 2% or even 1.5% then the Bank of England would not have to cut interest rates again – it may even have to put them up. And that would mean a higher income for the millions of retired people who rely on their savings to give them a decent income.

Spring 2002

e-mail Paul Lewis on paul@paullewis.co.uk