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What is inflation?

Distracted by the noise of the financial markets and signs that interest rates are beginning to claw themselves back from record lows, it can be easy to overlook the silent threat of inflation. But what actually is inflation, and how does it impact your savings?

What is inflation and why is it important?

Put simply, 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.

Gauging how these prices fluctuate over time, the rate of price growth is reflected through the consumer price index (CPI).

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.

Why is inflation key to the economy?

Inflation and the economy are closely linked. In a growing economy, consumers and businesses spend more, with increased demand pushing up prices. But, as demand weakens, so does price growth, and the economy enters a period of disinflation, before deflation – falling prices – takes hold.

Higher than expected inflation can signal an overheated economy,  where sharp rises in prices lead to supply inefficiencies. This environment can actually hinder economic growth as it reflects a rate of growth that is unsustainable and can be a precursor to a recession.  

Central Banks use inflation to help guide monetary policy decision-making.

When inflation looks like it might get too high, Central Banks might want to unwind some of the economic momentum by raising interest rates. In theory, this makes borrowing more expensive and saving more attractive.

When Central banks want to stimulate the economy and encourage spending, they might lower interest rates to make borrowing cheaper and saving unattractive. With more consumers spending, higher demand for goods and services will cause prices to rise.  

Changes in monetary policy can impact the financial markets significantly. For example, it was stronger than expected jobs data from America that brought volatility back to the market – not the geopolitical tensions many had expected.

How does inflation affect my savings?

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

Say you kept your £20,000 ISA allowance in a cash savings account offering a 1% interest rate, you’d have £20,200 after one year. That looks good on the face of it as you’ve earned a return just for keeping your money in a savings account.

However, if inflation runs at 2%, the Bank of England’s target, you need to make £400 just to retain the value of your initial deposit.

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.  

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By making an investment, your capital is at risk.

How can I offset the impact of inflation on my savings?

UK investors are faced with the real dilemma of trying to protect their money from inflation.

Although cash is traditionally viewed as a ‘safe haven’ asset, money that’s being kept in a savings account over the long-term could be losing value if the interest rate isn’t higher than inflation.

Now, savings accounts like cash ISAs play an important role in financial planning. If you have a low tolerance for risk or a short time horizon, cash savings accounts can be a good place to keep your money to offset some of the impact of inflation.

But if you’re keeping your money in cash for the long term, inflation can seriously eat into the purchasing power of your money over time.

Those that are fed up with the lacklustre savings environment are turning to the financial markets in search of inflation-beating returns. By taking on a bit more risk with your money, you hope to protect your money and grow it for the future.

Risk is one of the most misunderstood concepts on the financial markets, especially when markets are experiencing short-term fluctuations. In the real world, risk means gambling and danger.

On the financial markets, it’s about balancing your tolerance for risk with your expected return to build portfolios that reflect you, your time horizon and goals. The more risk you take with your money, the higher the return you can expect – although the further the value of your investments can also fall.

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.

Strategies to offset inflation

If you’re investing to offset the impact of inflation, you’ll want to know you’re doing the right things with your money to protect your wealth and grow it for the future. When you’re juggling managing your money with your career and the school run, this isn’t always easy.

Whilst many investors scramble to find the best investment strategies for them, one of the only things you really need is time.

A long term time horizon encourages you to ride out any short-term fluctuations on the financial markets, and take on more risk with your money as your investments will have longer to recover from any volatility along the way.

Remember to put yourself first when investing for your future. By building an investment portfolio that reflects your investor profile, time horizon and attitude to risk, you can position yourself for long-term growth.

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