Understanding inflation

You’ll probably hear the word inflation in the news quite a lot and have a vague understanding of what it means, but the ins and outs are actually very complex.

What is inflation?

Inflation is the word we use to describe the increase in prices over time. When prices rise across the board, the money you have won’t be able to buy you as much as it once did, so inflation also refers to a reduction in the buying power of money.

To explain that in real terms, we’ll give an example using our chocolate friend, a Freddo. Today, a Freddo costs 25p but back in 2005 it only cost 10p. So, if you took £1 to the shop in 2005, you could come home with 10 Freddos. But, if you did the same today, your £1 would only buy you four - which is pretty outrageous!

Who controls inflation?

Inflation usually occurs when a surge in demand for products and services causes a rise in prices. The Bank of England is tasked by the government to keep inflation below a rate of 2% and it does this by controlling interest rates.

Bank of England: The central bank of the UK. It has a wide range of responsibilities including producing bank notes and keeping the cost of living stable.

When interest rates are low, inflation tends to rise because of increased spending. People’s response to low interest rates is to spend and buy now rather than later, because the cash they have will only lose value and people and businesses spend more through taking on additional debt because the interest rates on loans and credit cards are lower.

A good example of this is the change in interest rates that followed the 2008 recession. To encourage consumers to spend money and support the economy, interest rates fell from 5.25% in February 2008 to 0.50% in March 2009.

When interest rates are high, inflation tends to fall so, if the cost of living is rising too quickly, the Bank of England can try to slow it down by raising interest rates, which is what we’ve seen happen most recently following the pandemic.

Interest Rate: Interest is what you pay for borrowing money, and what banks pay you for saving money with them. The interest rate is shown as a percentage of the amount you borrow or save over a year.

Will inflation affect me?

Inflation affects everyone, because the rate of inflation has a direct impact on the cost of living. Rising inflation will result in you paying more for the same products and, unfortunately, most people don’t get a pay rise to help cover these increased costs. So, the money you have won’t go as far as it once did and you’ll have less disposable income at the end of each month.

As we talked about above, the Bank of England do try to manage this by raising interest rates, however, even when they do this, interest rates are rarely higher than the rate of inflation so the money you have in savings will still effectively lose money over time. This doesn’t mean the balance of your account will reduce, it just means that the amount that money will be able to buy you will reduce.

This is why it’s a good idea to understand inflation and make yourself aware of the current rates and how they may change. It’ll mean you can be savvier with your money and make sure you’re taking steps to put yourself in the best financial position possible.

What’s the current rate of inflation?

Inflation is quite a hot topic at the moment as it’s the highest it’s been in over 30 years. Prices have risen sharply over the past 12 months and that has resulted in the current rate of inflation being 6.2%, which is even higher than the experts predicted.

It’s then set to increase even further, reaching around 7% in Spring, before starting to come down shortly after. The Bank of England has predicted it’ll be back to a more manageable level in around two years, saying:: “Most of the causes of the current high rate of inflation won’t last. It’s unlikely that the prices of energy and imported goods will continue to rise as rapidly as they have done recently. And this means that inflation will decline. We expect it to be much closer to our 2% target in two years’ time."

Why is inflation rising so much now?

The main reason inflation is rising so much at the moment is because of the rising global price of energy. This has meant that businesses have had higher energy and transport bills to pay, and the majority will pass these extra costs down to you and I – the customer.

Supply issues and staff shortages are another big problem in the UK, largely as a result of Brexit and the pandemic. This is prompting some employers to raise wages. While this can be a good thing for those getting the increased wage, it will actually contribute to rising inflation too, because again these increased labour costs are passed down to the customer.

Finally, many people remained employed or furloughed during the height of the pandemic but were unable to go out and spend their money on eating out, holidays and travel. Since the lockdowns were lifted, people are spending again causing a surge in demand for products and services which will be continuing to contribute to the rise in inflation.

Can inflation ever be good?

In moderation, inflation can be considered a good thing as it’s a sign of a healthy economy. However, if it gets too high – like it is currently – the cons certainly outweigh the pros because it can result in a lot of people facing financial troubles.  

Deflation is also possible but is not always as positive as it sounds. If all bills were falling by 50%, you would probably think that would be a good thing. While it would certainly have some perks, deflation can actually contribute to lower economic growth. Deflation increases the real value of money and debt, which makes it more difficult to repay debt and, consequently, consumers and businesses have less to spend and invest. Deflation also encourages people to hold off on spending, particularly on luxury and non-essential items, anticipating that prices will drop in the future, again, reducing economic growth. The reduction of spend can mean that businesses make less money and this can cause unemployment and further reductions in spending – it's a vicious cycle.

Deflation: Deflation is essentially the opposite of inflation. It refers to a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy.

So, as strange as it seems, some inflation is a good thing – just not when rates are as high as they are the minute.

What should I do about inflation?

Unfortunately, there’s no sure way to beat inflation. In theory, all you need to do is put your money in a product which will pay you a higher rate than the current inflation rate, but the challenge today is very few accounts actually do – and those that do only accept very small deposits.

Our advice is, if you will need access to your savings in the near future, shop around to find a cash savings account with the highest rate for the amount you’re expecting to save and keep your money there until you’re ready to spend, this could help to reduce the impact.

However, if you’re planning to put your savings aside for five years or more, a cash saving account is generally the worst place to keep your money. The interest is almost always lower than inflation so it might be better to consider investing. With investing, your returns aren’t tied to any fixed interest rates so, over the long term, there’s a chance you will end up with higher returns than the rate of inflation – but remember, it’s not guaranteed!

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