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What is inflation?

Distracted by the noise of the financial markets and the headline interest rates dropping, it can be easy to overlook the silent threat of inflation. But what is inflation?  

Inflation defined

Inflation measures the rate of price growth for general goods and services by monitoring the value of an extensive shopping basket of items. Compiled by the Office for National Statistics, this list includes the price of chocolate, bread and cheese, as well as essential services like transport, and is updated once a year.

Inflation gauges how these prices fluctuate over time. In a growing economy, consumers and businesses spend more, with increased demand pushing up prices. This is reflected through the consumer price index (CPI).  As demand weakens, so does price growth and the economy enters a period of disinflation, before deflation – falling prices – takes hold.

It makes sense that Central Banks use inflation to help with monetary policy decision-making. Whilst higher than expected inflation can signal an overheated economy and may trigger tightening of monetary policy, Central Banks may loosen the strings if price growth is weaker than expected.

Commodity prices, especially oil, have a tight grip on CPI; when the price of oil rises, so does the cost of manufacturing goods and services.

Investors and savers need to keep an eye on the rate of inflation, as it reduces the purchasing power of money over time.   

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Say you kept £1,000 in a cash savings account offering a 1% interest rate, you’d have £1,010 after one year. If inflation runs at 2%, the Bank of England’s target, you’d need £1,020 to account for higher prices.  As the return from your savings account has failed to keep up with inflation, you won’t be able to buy as much with your money as you could last year.  

Dilemma facing UK investors

With inflation running at 2.6%, this is a real dilemma facing UK investors. Although cash is traditionally viewed as a ‘safe haven’ asset, money that’s being kept in a savings account could be losing value if the interest rate isn’t higher than inflation.

Those that are fed up with the lacklustre savings environment are turning to the financial markets in search of inflation-beating returns – although you still need to factor in the impact of inflation when calculating your returns.

Equities have traditionally been used as a good hedge against inflation, with company earnings rising in line with the price of goods and services. Bonds, however, have a more tumultuous relationship. Bonds in the fixed income space might offer reliable income, but as this usually remains the same until maturity, inflation chips away at the value of these returns. Floating-rate bonds have coupons that are linked to key interest rates, or inflation-linked bonds, are issued by governments and tied to inflation. But every investment carries risk.

Whilst savers and investors could see weak inflation as a good thing for protecting the value of their money, poor inflation can also be a sign of a weakening economy, or one that is stagnant. In this case, interest rates could be cut, which will restrict the scope for returns on cash savings further.

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