Whether you are looking to invest for your future, save for retirement, or find your perfect mortgage you have probably come across a term called inflation. With its widening effect, it is important to understand what inflation is, why it is necessary, and how it affects the economy. Below we have compiled a guide to answer these key questions.
An economist will tell you that inflation is the term used to describe the general rise in the price of goods and services over a certain period. Put another way, inflation is when money loses value over time.
To illustrate, imagine a loaf of bread. In 2000, the average price of a loaf of white bread was a mere 69 pence. Now, after inflation, that same loaf of bread costs £1.22 according to the Office for National Statistics (ONS).
So, £1 now will buy you less than what it would have bought back in 2000 – that is due to inflation, and a reduction in the purchasing power of money.
Inflation is calculated as a percentage, so if a loaf of bread cost £1 this time last year and £1.05 now, then the annual rate of inflation on a loaf is 5%.
By looking at the changes in the price of a whole host of goods and services, economists work out whether the cost of living in general is going up or coming down.
In the UK, the two main measures of inflation are the Consumer Price Index (CPI) and the Retail Price Index (RPI).
RPI is usually higher than CPI because they each look at a slightly different 'basket' of goods and services – RPI, for instance, includes housing costs such as mortgage interest, rent and council tax, whereas CPI does not.
When it comes to CPI and RPI, both rates are measured and released monthly by the ONS.
The figure for CPI is calculated by collecting around 180,000 prices of 700 different items, from around 140 different locations across the UK.
These items are known as the “basket of goods”, which is constantly being updated and revised.
Such items are tangible, and include food, alcohol, and clothing. Others are more intangible such as university and medical fees.
While the general rise in prices seems like bad news for consumers, it plays a significant role in the economy.
In essence, inflation in moderation encourages people to spend their money, which in turn grows the economy and decreases unemployment.
Without inflation, prices would remain consistent across the board, meaning it would become more competitive for businesses to sell their products or services. When this occurs, businesses could drop their prices to become more competitive. Lower prices generally lead to less consumer activity as people hold off spending in the hope of getting better deals in the future.
As stated, inflation in moderation is a sign of a healthy economy. Currently, the Bank of England (BoE) has set a CPI rate of 2% as a healthy target for the economy, and if inflation falls more than 1% either side of this target then the BoE is obliged to tell the Government why.
It is only when it increases or decreases out of this realm that it is deemed as having a negative impact on the economy.
If inflation becomes too high, and prices grow out of control, the cost of living rises out of control too. Consumers will become poorer, limiting their disposable income, and spending on non-essential items like holidays and nights out.
In extreme cases, where inflation increases by more than 50% per month, an economy would experience hyperinflation. As seen with countries like Zimbabwe, governments could print more money to pay off their debt, but this will only weaken the currency further, forcing consumers to hoard items as prices spiral out of control.
On the other hand, deflation is feared just as much as high inflation. When prices decrease, people spend less in the hope of better deals in the future meaning businesses receive less for their products or services. As a result, there are inevitable layoffs and higher unemployment. With higher unemployment, there are fewer workers earning a salary, which forces consumers to tighten their spending further. This puts additional strain on businesses who will start the cycle again by laying off more workers.
When inflation rises consumers are encouraged to spend more. Knowing that their money will be worth less in the long-term, they will want to spend in the present rather than risk paying more in the future.
In theory this logic also extends to businesses, who will be discouraged from putting off larger capital investments for the future.
Added to this, businesses will be wary of rising interest rates which often accompany high inflation. This is because inflation and interest rates have a special relationship. When inflation rises too high, central banks often raise interest rates. Likewise, when inflation is low, central banks drop interest rates.
In essence, interest rates are used as a tool by central banks to control inflation. When inflation rises and the central bank raises interest rates, it is increasing the cost of borrowing. This means starting a business, financing a new car, or even borrowing to expand your company becomes more expensive too. People are then encouraged to save their money instead to protect their purchasing power, thus slowing down the economy and protecting the value of the currency.
If the amount of economic activity slows too much, central banks can then drop interest rates to make borrowing more attractive. This will encourage economic growth and prevent deflation.
Anyone who is borrowing money over a fixed period benefits from inflation. This is because, as the value of money decreases, the value of their debt begins to fall away. For example, if you take out a fixed loan of £20,000 over 10 years, by the time you reach the tenth year the value of £20,000 will be worth less and your repayments will be a smaller percentage of a salary which is adjusted for inflation.
In order to protect yourself against the effects of inflation, you can fund an emergency account, fix your mortgage, and adjust your lifestyle.
It is important to make as much of your money as possible work for you. If you have any disposable income in your current account which is not being used, then consider building an emergency fund in an easy access savings account. These accounts allow you to access your money at a moment’s notice, while paying interest on your funds. To view the current best rates on the market, view our tables here.
If you believe inflation will consistently rise over the long-term, then it is only logical that the BoE will continue to raise interest rates. In this case, consider fixing your mortgage rather than opting for a variable mortgage. This will protect you from paying inflation-based increases on your mortgage and ultimately save you money in the long-term.
One of the most basic ways to beat inflation involves lowering your standard of living. Look at your monthly expenditure and cut out for unnecessary luxury items. Perhaps consider switching to a cheaper supermarket and your loyalty towards big-name brands on the shelves.
During periods of moderate inflation, investing in the stock market can be a good idea. This is because a company’s revenue moves according to inflation, which then means dividends are adjusted for inflation too.
However, periods of high inflation impact the stock market negatively. This is because the rising cost of prices increases a business’s expenditure. This minimises its profits, which in turn devalues its worth. As a result, investors could find their shares in this company overvalued, encouraging them to sell them on for inflation-averse investments.
Putting your money into commodities or real estate could help you beat inflation.
When becoming a buy-to-let investor, your rental income will increase with inflation, meaning your earnings will increase accordingly too. In addition to this, house prices, as an appreciating asset, tend to increase during periods of inflation which means you could sell your property off for a tidy profit. Another effect of rising house prices is that it makes it more difficult for first-time buyers to get on the property ladder, thus increasing the rental demand for property too.
Those looking for a shorter-term hedge against inflation could opt for commodities. This vehicle of investment is used to describe investing in raw materials, such as oil, metals, or even food sources, which are used to create other products. Like inflation and interest rates, inflation and commodity prices hold a special relationship too. When inflation rises, the price of goods rises, and so does the price of the commodities which are used to produce these goods. Likewise, when inflation drops, so does the price of the commodities used to make products.
Gold is known to protect your money in times of high inflation. This is because the metal is known as a store of value, and there is only limited supply across the world.
To illustrate how the value of gold has risen over time, consider this example. On 31 December 1999 gold ended the millennium at £179.61 per ounce (oz) according to the World Gold Council. Extrapolate this over 22 years into the future, after the financial crisis of 2008 and during the COVID-19 pandemic, and that same ounce would be worth over £1,300, which is well above the rate of inflation.
Like other goods and services, house prices are known to increase during inflation. However, inflation alone is not strong enough to determine house prices and there are a lot of factors which ought to be considered. This includes demand and interest rates.
In addition to this, your individual house price will also be determined by a host of other unique factors such as your location, your property’s condition, and any home improvements you may have added.
With that said, the price of houses under construction can increase the most during periods of high inflation. This is because in cases where the cost of raw materials rise, the more expensive it becomes to build a new house. As a result, developers can put up the price of these new homes to keep up with inflation.
If inflation rises, interest rates will likely follow suit too. This means you will likely earn more on your savings account as different providers begin to offer better rates.
Savers are always recommended to compare their interest rate to the rate of inflation, if their interest rate cannot beat the rate of inflation, then over time you will not make any money.
Demand pull inflation is when demand for a particular product or service outstrips supply, therefore forcing businesses to raise costs. This generally occurs when the economy is growing too fast.
Cost push inflation is caused by the rise in prices of raw materials. This then forces business to raise the cost of its products or services in order to keep profits at a consistent level.
Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.