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What is inflation?

Inflation in the UK is, currently, low. Sitting at just 0.5% – well below the Bank of England target of 2% – it’s dipped considerably in 2020 as a result of the Covid-19 pandemic.

But what does this mean? What is inflation? And how do such seemingly small differences in percentages impact your savings?

What is inflation and how is it measured?

Put simply, inflation consists in the rate of price growth for general goods and services and is most typically measured through the Consumer Prices Index (CPI), which monitors the changes in price of an extensive shopping basket of items that consumers commonly spend money on. 

Compiled by the Office for National Statistics, this list is updated once a year and may include the price of basic goods such as milk, bread and cheese, as well as essential services like transport. Prices of items are weighted based on the extent people spend on those items. The price of electricity will affect inflation rates more than the price of stamps, for example.

What causes inflation?

The reason behind the UK’s target inflation rate (2%) is that inflation and the economy are strictly interlinked. To understand how, let’s take a look at what causes inflation.

In the event of cost-push inflation, prices increase for consumers as a result of a rise in prices for businesses. For example, an end product may come to cost more due to an increase of costs in materials, transport, taxes or wages.

In the event of demand-pull inflation, prices increase as a consequence of a demand-supply gap, where demand is greater than supply. Because more people are willing to spend for something that is not produced sufficiently, prices rise.

Why is inflation important? 

Central Banks use inflation to help guide monetary policy decision-making. Basically, inflation rates are used by Central Banks as a basis for setting interest rates.

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.

Conversely, 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 may cause prices to rise.  

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.  

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 sitting in a savings account could lose value in the long term, if inflation is higher than the interest rate. 

Those that are fed up with the lacklustre savings environment are turning to the financial markets in search of inflation-beating returns. This could help protect your money and allow for it to grow for the future. However, different investment products react differently to market fluctuations and inflation.

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.

Photo by Kid Circus on Unsplash

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