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What exactly is inflation?
The textbook answer is that inflation refers to the increase in the cost of goods and services over time. Basically, inflation impacts you directly, increasing the cost of almost everything you buy and every bill you pay.
The rate of inflation is measured by comparing today’s prices with the same costs a year ago. The average increase across a range of goods is the inflation rate.
If an item cost £1 a year ago, with inflation at 5% it would cost £1.05 today. The continual increase in prices makes a big difference as you get less and less for your money over time. As Warren Buffet said, “Price is what you pay. Value is what you get.”
What is the current rate of inflation?
The current rate of inflation in the UK has risen to around 9.0% up from 7.0% in March, the highest level since 1992. In the US this figure is currently at 8.3%, its highest level since 1982.
How is inflation measured?
In the UK the Office for National Statistics (ONS) monitors the price of a “basket of goods”. This is a broad range of products that aims to reflect consumer spending which is reviewed annually with new products added and less relevant ones removed.
This is known as the Consumer Price Index and is one of the most commonly quoted figures. Items such as gin and smartphones have found their way into the basket as trends change over time.
The problem with this measure it that it is heavily manipulated by governments to ensure the final figure suits their political needs. Even now, during a period of very high inflation, the real figure is much higher than the CPI suggests.
Items which have gone up in price significantly are substituted for cheaper alternatives where possible. It’s shocking to think that were constantly having the wool pulled over our eyes but the reality is, it’s happening all the time behind the scenes.
Why is inflation rising?
There are a number of factors currently affecting inflation. In the UK the energy price cap was increased in April leading to a rise in fuel bills for millions of customers. In addition, disruption to supply chains and increases in the cost of many raw materials used in manufacturing has also resulted in a sharp rise in the cost of many other household goods.
Another big (and sometimes overlooked) contributor to inflation is the fact that the Bank of England keeps printing more and more money. By this I mean Quantitative Easing. Notes aren’t actually being printed. The money doesn’t actually exist. Its just another zero added to a ledger somewhere on the Central Banks spreadsheet.
Once the money has been created, it finds its way into the economy through bank lending and increased Government spending. This would be similar to you hacking your current account and adding a couple of zero’s to the end of your balance. You’d more than likely go to prison but Central Banks do this regularly.
The problem with QE in terms of inflation is that, as with anything, the more of it there is the less its actually worth. It’s simple supply and demand, and the reason that rare items such as works of art are so expensive.
The result of QE therefore, is that the more money they print, the less each pound is actually worth. In other words each pound in your pocket will buy less stuff = inflation.
How does inflation affect my money?
It really depends on your circumstances. The most obvious immediate impact is on the cost of living. The recent rise in energy bills is likely to be the one that hits hardest, potentially taking the average price of gas bills in the UK to almost £2000 per year.
The days of switching to a cheaper deal are gone for the foreseeable future and if you’re coming to the end of a fixed contract, you’ll see a big difference in the cost of heating your home.
Many smaller energy suppliers have gone to the wall as they were prevented from passing the cost of wholesale gas onto customers by the governments price cap. As a result, this cap is set to rise again later this year
What is the effect of inflation on my savings and investments?
What’s less obvious is the effect of inflation on your savings and investments. Currently interest rates offered by banks in the UK for easy access accounts are well below 1%. If the rate of inflation is above this figure your money is losing its value in real terms.
In addition, if you take a fairly conservative approach to investing your money, you could find that any returns are completely wiped out by rising inflation.
What about the effect of inflation on borrowing?
The link between inflation and interest rates doesn’t end there. Eventually the Bank of England in the UK or Federal Reserve in the US will raise interest rate rises to discourage spending and encourage saving. This in turn reduces demand for products and therefore brings down prices. If you have any outstanding debt this will increase your monthly repayments.
What can I do to protect myself from Inflation?
Unfortunately, it’s impossible to avoid paying more for essential goods and services. There are however some simple steps you can take to reduce the impact of these price hikes. If you have an existing variable rate mortgage for example, you could prepare for the inevitable rate rises by switching to a fixed rate product.
If you’re saving specifically for retirement and don’t need to access your money in the short term, a good place to start would be to increase your workplace pension contributions.
This is because in most cases your contributions are taken from gross pay i.e. before tax which is effectively a 20% gain when compared to placing the same amount in a savings account.
It may be beneficial to invest your money rather than saving. See our beginners guide to investing to find out how you could stay ahead of the game.
Conclusion
The bottom line is that inflation is gradually reducing the value of your money in real terms. Thankfully there are a number of simple steps you can take to protect yourself.
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