When interest rates could go down in 2023 and what it would mean for you (2023)

The UK remains in the grip of a cost of living crisis that is putting significant strain on household wallets.

The Office for National Statistics (ONS) says 93 per cent of adults have reported an increase in their living costs compared with a year ago, with poorer households disproportionately affected.

More than a fifth of UK households (22 per cent) would only be able to last a month before facing financial difficulties if the main earner became too ill to work, according to research published in January from Direct Line Life Insurance, while 55 per cent would struggle within a year.

The ‘cost of living crisis’ refers to the fall in ‘real’ disposable incomes (that is, adjusted for inflation and after taxes and benefits) that the UK has experienced since late 2021,” the Institute for Government explains.

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“It is being caused predominantly by high inflation outstripping wage and benefit increases and has been further exacerbated by recent tax increases.”

Here’s what we know about when inflation could fall, how this affects you, and what it means for your money.

What is inflation?

Inflation is a measureof how much the prices of goods and services increase over time. It is one of the most relevant economic measures for consumers as it affects their buying power and has an impact on everything from fuel prices to mortgages, as well as things like the price of train tickets and the cost of shopping.

Inflation is usually measured by comparing the cost of things today with a year ago. This average increase in prices is known as the inflation rate.

If the rate of inflation is 1 per cent, it means that prices are higher by 1 per cent on average. For example, a loaf of bread that cost you £1 a year ago will now cost you £1.01.

How is inflation measured?

In the UK, inflation is measured by the Office for National Statistics, which produces three main estimates of inflation: the CPI, the Consumer Price Index Including Housing Costs (CPIH), and the Retail Price Index (RPI).

To calculate the CPI – the most commonly used figure – theONS looks at the prices of thousands of goods and services across the UK, and compares them year-on-year.

The items used in the basket to compile the various measures of price inflation are reviewed each year. For example, in 2019 smart speakers were added to the list of items monitored to ensure the UK’s measure of the cost of living reflects the public’s spending habits.

When will inflation go down?

Inflation fell again in December, it was reported this week, dipping from 10.7 to 10.5 per cent.

This is only down slightly from the 40-year high of 11.1 per cent seen in October 2022, but back-to-back declines is providing hope that the UK now is past its inflation peak.

Rishi Sunak has pledged to halve inflation by the end of 2023 – but this was already forecast to happen. The Bank of England is expecting inflation to fall sharply from the middle of the year, for three main reasons.

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“First, the price of energy won’t continue to rise so quickly. The Government has introduced a scheme that caps energy bills for households and businesses for six months,” the Bank says.

“Second, we don’t expect the price of imported goods to rise so fast. That’s because some of the production difficulties businesses have faced are starting to ease.

“Third, we expect there to be less demand for goods and services in the UK. That should mean the prices of many things will not rise as quickly as they have done.”

The Bank of England’s target inflation rate is 2 per cent. It has been raising interest rates in order to achieve this.

When will interest rates go down?

On 15 December, 2022, the Bank of England raised interest rates by 0.5 per cent, to 3.5 per cent. It will next adjust rates on 2 February.

Raising interest rates means people face higher borrowing costs and businesses face higher loan rates, but higher interest rates also slow price rises down, leading to lower inflation in the long run.

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The Bank is expected to be able to lower interest rates later in the year, once inflation has returned closer to its target.

“Overall, we know that if we lower interest rates, this tends to increase spending and if we raise rates this tends to reduce spending,” the Bank says.

“So, to meet our inflation target, we need to judge how much people intend to save and spend given the current interest rates. For example, if people start spending too little, that will reduce business and cause people to lose their jobs. In that case we may cut interest rates to help support spending.”

What do lower inflation and interest rates mean for me?

A little inflation can be good for the economy as it can encourage shoppers to buy sooner. When prices are going up, consumers will want to buy now rather than pay more later, which increases demand in the short term and can boost productivity.

However, a high inflation rate means people can buy less for the same amount of money. This means they may have to spend more on food, energy bills and filling up their car.

One of the consequences of inflation remaining high is the prospect of the Bank of England further increasing interest rates and the knock-on impact on mortgages, i deputy money editor, Grace Gausden, reports.

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She advises: “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 unless they have been able to overpay in the run-up to the end of their deal. The Bank estimates average repayment hikes of £250 per month when homeowners switch onto a new product.

“People remortgaging now should consider opting for a variable-rate loan with no penalty for switching, which will allow them to fix when rates come down.

“A higher cost of living hurts disposable incomes, something lenders examine carefully when assessing a borrower’s creditworthiness, which will have a knock-on effect on house prices.”

This means first-time buyers may not be able to borrow as much as they could a year ago, while people looking to refinance at a time when house prices are expected to slide may find their loan-to-income ratio is adversely affected.

If inflation returns to the Bank of England’s 2 per cent target, interest rates will also go down again, making mortgages more affordable.

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