Inflation can impact our finances in a number of ways – from the cost of our weekly shop, to the value of our long-term savings – but what exactly does it mean?
It’s important to understand how inflation works, as well as the effects it could have on your financial planning.
What is inflation?
Inflation is often referred to as a “measure of the increase in the price of goods and services over time”. Inflation not only affects the cost of living – things such as transport, electricity and food – but it can also impact interest rates on savings accounts, the performance of companies and in-turn, share prices.
As measures of inflation rise, this reflects a reduction in the purchasing power of your money. In other words, this impacts your ‘buying power’, as you’re now able to buy less with your money.
Measuring rates of inflation
In the UK, there are two main inflation-rate measures;
- the Consumer Price Index (CPI) and;
- the Retail Price Index (RPI).
They look at different items and are calculated using different formulas. The CPI covers the cost of hundreds of items that households are likely to purchase – many on a daily or weekly basis – including things like food, clothing, cinema tickets, etc.
The CPI doesn’t take into account housing costs and mortgage interest payments, as this is included in the RPI measure. The RPI measure is used to index various prices and incomes, including tax allowances, state benefits, pensions and index-linked gilts. RPI has been superseded in recent years by CPI and is no longer formally ranked as a UK National Statistic.
Although we are unable to stop the rates of inflation, taking measures to protect your wealth could help to limit its harmful impact.
How will inflation affect my money?
When it comes to the cost of living, a rising inflation measure means it has become more expensive to maintain our previous lifestyle. If your income hasn’t increased over the measured period by at least the rate of inflation, then your buying power will have fallen, as the costs of goods and services will have increased over that time.
Inflation doesn’t just affect our everyday expenses, but could also impact our savings, investments and pensions.
Cash savers could be hit particularly badly, as the purchasing power of our money falls. Consider the following example: if you invest the amount needed to buy a car into a bank account for 5-years – at an annual interest rate of 1% – and the cost of cars over the same period increases by 2% per annum, then at the end of the period you would need to add more money to be able to buy the car.
Think about how the cost of living has already changed since you were a child. A high rate of inflation combined with a low rate of interest, means the money we have saved in potentially poorly performing savings accounts could be seriously hit, having a detrimental effect for cash savers.
If inflation, as is usually the case, is higher than interest rates, then in real terms your returns will become negative, meaning you may want to think about whether cash is the best place to stay in the long-term (for instance, high street savings accounts and cash ISAs.)
You could consider alternative methods for saving, such as investing in assets that have traditionally increased at a higher rate than inflation. Options could include considering investments that are inflation-linked, like some National Savings Accounts or government loans, investing in property, or in stocks and shares.
For those saving for their retirement, high rates of inflation can erode the buying power of your pension fund when you need it. If you have a defined benefit pension scheme that escalates in payment by CPI, this is a huge advantage. However, those retirees reliant on fixed annuity pension income will see the future buying power of their fixed pension diminish, as bills and prices rise.
If you’re saving for retirement, it’s vital that investment performance of funds (after all costs) is monitored regularly. Where a fund’s performance – measured over a reasonable period – fail to beat the rate of inflation, then alternative strategies should be considered to ensure that funds are growing in real terms.
It’s important to understand that the cost of an income that rises with inflation and is therefore protected, is significantly more costly than a level income.
As an investor, you should try to buy investment products with returns that are equal to, or greater than, inflation.
You can protect your purchasing power and investment returns over the long run by investing in a number of inflation-protected securities, such as inflation-indexed bonds. Investments such as this move with the rate of inflation, meaning they are not subject to inflation risk.
Inflation isn’t all bad. For those with debts and mortgages, the effect of inflationary pressure is to reduce the value of debt in real terms. A good example of this would be to ask your parents about the cost of their first home. The mortgage they took out originally to purchase the property will usually be a fraction of the cost of purchase today, with significantly less borrowing requirement.
Still unsure about inflation and its effects?
The effects of inflation can impact our money in all kinds of ways, so it’s important to have an overall view of your finances and protect your wealth where possible. If you’re not sure what action to take, an independent financial adviser at AFH can help, creating a financial plan that keeps you on track to meet your aims and objectives.
This article is for generic information only and should not be construed as advice. Please contact us before proceeding with any course of action.