What Have We Learned From Rising Interest Rates?

One lesson is that turning points are almost impossible to predict. When the Bank of England first cut its rate to 0.5% in March 2009, the expectation was that it was a temporary measure in response to the global financial crisis and might last a year or so. Nobody foresaw that a decade later the rate would be just 0.25% higher and heading towards a new low of 0.1% in March 2020.

A lesson relearned has been that Bank of England increases in interest rates reach borrowers with variable rate loans quicker than they do depositors with instant access accounts. Throughout the period of rising rates, banks and building societies have grabbed the opportunity to widen their margins. The lenders’ actions have prompted criticism from the Chancellor and scrutiny from the Financial Conduct Authority (FCA). However, the Government has quietly widened some of its own margins. At the time of writing (early September 2023) the National Savings & Investment Direct ISA was still paying only 3.0% - more than 2% below the Bank of England’s Bank Rate.

Another lesson which will be new to all but the grey (and no) hairs is that high interest rates offer little or no protection to capital in times of inflation. This was true in the 1970s and is equally true today, but is easy to overlook if both high inflation and high interest rates are unfamiliar backdrops. For example, go back to August 2020, when inflation was 0.2% and the Bank Rate was 0.1%. If you were earning Bank Rate on your deposit, then your interest earnings were only 0.1% behind inflation. Three years later, the corresponding interest rate was a much more attractive 5.25%, but inflation (for July 2023) was 6.8%, making the losing gap 1.55%.

There is a corollary to the widening rates differential in another lesson: your cash holdings need your attention. This was arguably less important when interest rates were on the floor. Now they are not, leaving too much cash in a current account or High Street bank deposit account could be costing you a meaningful amount of income. No wonder many banks have argued against informing their customers of alternative, higher earning accounts…

And then there is the question of tax…

Tax on interest disappeared for most people on 6 April 2016, when the personal savings allowance (PSA) was introduced. The basis of the PSA has not changed since then:

• If you are a UK basic rate taxpayer, then the first £1,000 of interest is tax-free;

• If you are a UK higher rate taxpayer, then the first £500 of interest is tax-free; but

• Your PSA is nil If you are an additional rate taxpayer – and there are many more top rate taxpayers in 2023/24 because of the near £25,000 cut in the additional rate threshold.

• Just to complicate matters, the PSA is not a true allowance, but a nil rate tax band.

When rates were 1% or less, for nearly all taxpayers, a substantial amount of capital was required to generate enough interest to exceed the PSA. Now, if you are a higher rate taxpayer, £10,000 in an account with a competitive rate could mean you have tax to pay (£20,000 if you pay basic rate). This could be both a surprise and a complication. It is some years since 20% tax was automatically deducted from interest, so any tax payable will be at the full UK income tax rate (Scottish income tax rates do not apply to savings income). Banks and building societies are required to inform HMRC about how much interest they pay to individual taxpayers, so any tax bill will eventually reach you, even if you are not required to complete a tax return.