Inflation fell last month, providing a glimmer of hope to those struggling to cope with steep living costs, but offering little comfort for savers.
The Consumer Prices Index measure of inflation dropped 0.2% to 5% in October, whilst the Retail Prices Index, which includes mortgage costs, also fell by the same amount to 5.4%.
The falls were attributed to heavy discounting by the major supermarkets, which is expected to continue until Christmas. Recent drops in the oil price are also starting to have an effect, with lower airfares and petrol costs contributing to lower inflation.
Even though inflation has fallen, it still remains more than double the government's 2% target, making it virtually impossible for savers to earn real rates of return.
However, many experts claim that inflation has now peaked and will continue to drop next year. Adrian Lowcock, senior investment adviser at independent financial advisers (IFAs) BestInvest said: "We expect inflation to continue to fall throughout 2012 as the rise in VAT works its way out of the measure.
The recent falls in oil will continue to have a negative effect on inflation, whilst the effect of energy costs, including gas and electricity, will reverse and in 12 months' time we could be seeing pressure on utilities to drop their prices."
Here, we take a look at what falling inflation would mean for savers, and where they can earn the best returns while the cost of living is still high...
Impact on savers
Lower inflation would be good news for savers as it means that their money would be able to maintain its purchasing power.
Currently, in order to beat inflation at 5%, as measured by the consumer price index (CPI), a basic-rate taxpayer at 20% would need to earn at least 6.25% on their saving, while a higher-rate taxpayer at 40% needs an account paying at least 8.33%.
No conventional savings accounts pay such a high rate of interest, so inflation-linked accounts are proving popular as they promise to keep pace with the rising cost of living.
Both the Post Office and BM Savings are among providers which offer this type of account, and both provide three-year and five-year savings bonds linked to RPI. With the Post Office's accounts, for example, the rate of return on its five- and three- year accounts is based on the annual RPI as measured in January each year, plus a guaranteed fixed return of 1% or 0.25% gross per year.
If inflation remains high, then these accounts offer an excellent way to keep pace with the rising cost of living. But, if, as many expect, inflation falls over the next few years, then you may only get back what you invested plus a paltry fixed rate of return.
Fix for the highest returns
If you think inflation is going to fall, and so don't want to go for an inflation-linked account, then your best bet is likely to be a fixed rate bond, as these tend to pay the highest rates of interest.
For example, a five-year fixed rate bond from Clydesdale Bank or Yorkshire Bank would pay an impressive 4.7% interest before tax. However, remember that while this rate looks very competitive now, it may not look quite as appealing in a few years' time once interest rates start to rise.
If you don't want to tie up your cash for as long as five years, Clydesdale and Yorkshire Banks both offer competitive bonds paying 4.3% over three years.
Other high-interest paying bonds over the same timeframe include the AA's 3 Year Fixed Rate Savings account, which pays 4.15% on a minimum investment of £1, Halifax's Fixed Online Saver account paying 4.11% on a minimum investment of £500, and United National Bank's three year fixed deposit account, which pays 4% on a minimum investment of £1.
And if three years still seems too long, then you can still find some impressive rates over 18 months and a year. For example, Yorkshire Building Society's Fixed Rate EBond pays 3.50% on a minimum investment of £1,000 until the end of March 2013.
If you only want to tie your money up for a year, then the current market-leading online one-year fixed-rate bond is from Aldermore, paying 3.46% on a minimum investment of £1,000.
Easy access needn't mean low returns
If you don't want to lock your money up at all, then your best bet is an easy-access account. While these returns don't beat inflation at its current level, at least you can get your hands on your money whenever you need to.
The current market-leading easy-access account is Coventry Building Society's Poppy Online Saver account, which pays an impressive 3.15% annual interest before tax on a minimum investment of just £1.
The rate includes a 1.15% bonus for the first 12 months, so you may want to move your money when this disappears. You can make up to four no notice penalty-free withdrawals from this account each year.
Alternatively, Nationwide's MySave Online Plus account pays 3.12%, but you can only make one penalty-free withdrawal a year from this account.
This rate includes a bonus of 1.58% which is only payable for the first year, so you may want to move your money at the end of this period.
Other easy-access accounts which are worth considering include Santander's eSaver Issue 4, paying 3.10% on a minimum investment of £1. Again this rate includes a bonus, so you will need to move your money after the first year.
Bank of Ireland's WebSave account and the Post Office's Online Saver Issue 4 account pay 3.05% and 3.01% respectively, and both of these accounts can also be opened with £1. These rates also include bonuses, so you should make a note in your diary when they end.
Don't forget ISAs
One of the best ways to maximise your savings returns is by making the most of your annual tax-free allowances.
This tax year you can invest £5,340 in a cash individual savings account (ISA) and the same amount in stocks and shares and returns are tax-free. Alternatively, you can invest the full £10,680 allowance in stocks and shares.
Kevin Mountford, head of banking at MoneySupermarket said: "Utilising your tax-free ISA allowance should be high up savers' priority list. Always making sure your savings are in an account which pays a good rate of interest may not beat the eroding effect of inflation, but it can certainly limit the impact."
Northern Rock's Online eISA, for example, which is exclusive to MoneySupermarket, pays 3.05% tax-free on a minimum investment of just £1. The account accepts transfers from existing ISAs.
Other competitive ISAs include ING Direct's cash ISA, paying 3.00%, again on a minimum investment of £1. This rate is guaranteed for a year, so you may want to move your money at the end of this period.
Please note: Any rates or deals mentioned in this article were available at the time of writing. Click on a highlighted product and apply direct.
By Melanie Wright, financial journalist for moneysupermarket.com
