Inflation
Overview
Good for:
Eroding value of debt
Potential for wage growth
Can stimulate economy
Keep in mind:
Inflation reduces purchasing power
Higher inflation may lead to high interest rates
Savings rates likely to lag
Inflation can erode the value of your savings over time, reducing your purchasing power and making it harder to achieve your financial goals.
When inflation is high, it's essential to take steps to protect and grow your savings. Here's a guide on how to how to try and safeguard your money during periods of rising prices.
1. What is inflation?
Inflation is the rate at which the general level of prices for goods and services rises over time, resulting in a decrease in the purchasing power of money. In simpler terms, as inflation increases, each unit of currency buys fewer goods and services than it did before.
While moderate inflation is considered healthy for an economy, high inflation can be damaging, as it reduces the value of money, leading to a decline in the real value of savings. This is why it's important to take steps to protect your savings when inflation rises.
2. How is inflation measured?
Inflation is typically measured by indexes such as the Consumer Price Index (CPI) or Retail Price Index (RPI), which track the changes in the prices of a basket of commonly purchased goods and services over time.
For example, if inflation is at 5%, an item that cost £100 last year would cost £105 this year. Conversely, the buying power reduces, so in this example, £100 last year would now only be able to purchase £95.24 worth of goods.
Inflation is a normal part of a growing economy, but when it becomes too high, it can significantly erode the value of savings and make everyday goods and services more expensive.
3. What is the right amount of inflation?
The "right" amount of inflation is typically considered to be moderate and steady, providing a balance between economic growth and price stability.
Central banks, like the Bank of England or the U.S. Federal Reserve, aim to maintain a target inflation rate of around 2% per year in most developed economies. This target is seen as an optimal level that encourages spending and investment without significantly eroding purchasing power.
Why 2%?
A 2% inflation rate is widely regarded as the "sweet spot" for developed economies. It strikes a balance between encouraging economic activity and maintaining price stability. At this level, inflation gently pushes consumers and businesses to spend and invest, knowing that prices will gradually rise over time. Meanwhile, it is low enough to avoid significantly reducing purchasing power, which could hurt the economy. By keeping inflation at or around 2%, central banks can foster an environment of sustainable growth while minimising the risks of both runaway inflation and deflation.
  • Encourages spending and investment: - Moderate inflation encourages people and businesses to spend or invest their money rather than hoard it, as the value of money decreases slightly over time. This fuels economic growth.
  • Reduces the risk of deflation: - Deflation, or a general decline in prices, can be harmful because it encourages people to delay purchases in the hope of lower prices in the future. A 2% inflation rate helps avoid this scenario by providing a small but steady increase in prices.
  • Wage growth: - Moderate inflation typically accompanies wage growth, ensuring that income levels keep pace with rising prices, maintaining the balance between cost of living and earnings.
  • Flexibility for Central Banks: - A small amount of inflation gives central banks room to lower interest rates to stimulate the economy during downturns. If inflation is too low or deflation occurs, central banks have less flexibility to manage economic challenges.
4. Dangers of too much or too little inflation
Inflation is a normal part of economic growth, but when it rises too high or falls too low, it can have significant consequences. Striking the right balance is crucial to maintaining economic stability. Let's explore the dangers of both high inflation and deflation, and their impact on wages, savings, and overall economic health.
High inflation (typically rates above 4-5%)
  • Erodes purchasing power: - High inflation means each unit of currency buys fewer goods and services over time. This reduces the real value of wages and savings, making it harder for people to maintain their standard of living. Those on fixed incomes, such as retirees, are particularly vulnerable.
  • Economic uncertainty: - High inflation creates uncertainty, deterring businesses from making investments and slowing economic growth. To combat inflation, central banks raise interest rates, making borrowing more expensive for consumers and businesses. This can reduce spending and lead to job losses.
  • Hyperinflation: - In extreme cases, inflation can spiral into hyperinflation, where prices rise uncontrollably. This leads to a breakdown in the value of currency, eroding wealth and causing severe economic instability. Countries like Zimbabwe and Venezuela have experienced such collapses.
Low or negative inflation (deflation)
  • Encourages delayed spending: - When consumers and businesses expect prices to drop, they hold off on purchases and investments. This reduces demand, slows economic growth, and increases the risk of recession. Deflation can create a cycle of decreasing demand, falling prices, and rising unemployment.
  • Increases the real value of debt: - Deflation increases the real value of debt, making it harder for households and businesses to repay loans. This can lead to higher rates of defaults and bankruptcies, putting pressure on the financial system and banks.
  • Discourages borrowing: - With deflation, the expectation of falling prices makes borrowing less attractive, as the real cost of repaying loans increases over time. This discourages businesses from taking out loans to invest in growth, and consumers from borrowing for large purchases like homes or cars, further slowing economic activity.
In summary, both high inflation and deflation pose serious risks to the economy. Moderate inflation, around 2%, provides a balance that encourages growth while maintaining stability. Central banks actively manage inflation to avoid these extremes and ensure long-term economic health.
5. Proactive measures when inflation is high
Inflation can reduce the value of your hard-earned savings, but with the right strategies, you can protect your money and even see it grow. By diversifying your investments, utilizing tax-efficient accounts, and focusing on inflation-resistant assets, you can minimize the impact of inflation and secure your financial future.
Take control of your savings now to safeguard against inflationary pressures and maintain your purchasing power over time.
Diversify your savings and investments:
One of the most effective ways to protect your savings from inflation is to diversify your assets. While cash savings lose value in high-inflation environments, investments in other areas such as stocks, bonds, and real estate tend to offer better protection.
  • Stocks & Shares ISAs: - Equities generally outpace inflation over the long term. Investing in a diversified portfolio through a Stocks and Shares ISA can help your money grow, even when inflation rises.
  • Commodities and real assets: - Assets like gold, silver, and real estate often retain their value or even appreciate during inflationary periods.
Consider inflation-linked savings accounts:
Certain savings accounts and bonds are designed to keep up with inflation. For example:
  • Inflation-linked bonds: - Some government bonds adjust their interest payments according to inflation, meaning your investment grows with the rising cost of living.
  • High-interest savings accounts: - While interest rates may lag behind inflation, finding a savings account that offers competitive interest can help reduce the impact on your savings.
Utilize tax-efficient savings options:
Using tax-efficient accounts can help your savings grow faster by reducing the amount of tax you pay on interest or investment returns.
  • Cash ISAs: - Although interest rates on cash ISAs may not always beat inflation, they still provide a tax-free shelter for your savings, ensuring you don't lose money to taxes on top of inflation.
  • Lifetime ISAs: - If you're saving for retirement or your first home, a Lifetime ISA offers a government bonus that can boost your savings, helping to counteract inflationary effects.
Invest in dividend-paying stocks:
Dividend-paying stocks can provide a steady income stream and may help protect against inflation. Companies that regularly increase their dividends often perform well in inflationary environments, giving you both income and potential capital growth.
Cut non-essential expenses:
High inflation periods can put pressure on household budgets. Reducing non-essential spending allows you to set aside more money to invest or save in inflation-resistant assets. Review your budget to eliminate unnecessary expenses and divert these funds into savings or investments that offer protection against inflation.
Consider fixed-rate investments:
Locking in current interest rates on fixed-rate investments can protect your money from losing value as inflation rises. Some options include:
  • Fixed-rate bonds: - These bonds offer a set interest rate for a defined period, allowing you to earn predictable returns regardless of rising inflation.
  • Fixed-rate cash ISAs: - Similar to bonds, these ISAs lock in a set interest rate, helping you avoid the impact of fluctuating inflation rates.
Re-evaluate your emergency fund:
While it's essential to maintain an emergency fund for unexpected expenses, cash held in savings loses purchasing power during inflationary periods. Consider keeping only what's necessary for short-term needs in a regular savings account and investing the rest in inflation-resistant assets.
Keep an eye on Central Bank policies:
Central bank actions, such as interest rate hikes, are often used to combat inflation. Keeping up with monetary policy updates can help you make informed decisions about where to place your savings. Rising interest rates could lead to higher returns on certain savings accounts or investment opportunities.
Explore inflation-resistant investments:
Certain types of investments are designed to perform well during periods of high inflation. These include:
  • Commodities: - Investing in commodities like oil, metals, and agricultural products can offer a hedge against inflation, as their prices often rise with inflation.
  • Real estate: - Property values tend to increase during inflationary periods, making real estate a popular investment during high inflation.
6. What asset classes are considered inflation-proof?
Certain asset classes tend to perform well during periods of high inflation, helping to preserve or even grow the value of your investments. These inflation-resistant assets are less vulnerable to the eroding effects of rising prices and often increase in value as inflation rises. Here are some of the most commonly considered inflation-proof asset classes:
Commodities:
Commodities like gold, oil, and agricultural products are often seen as a hedge against inflation because their prices typically rise with inflation. As the cost of goods increases, the prices of raw materials used to produce them also go up, making commodities a valuable asset in inflationary periods.
  • Gold: - Historically, gold has been one of the most reliable hedges against inflation. When the value of currency declines, investors often turn to gold as a store of value.
  • Oil and Energy: - Rising demand and geopolitical factors often drive up the price of oil during inflation, making it a strong inflation hedge.
  • Agricultural Products: - Food prices tend to increase with inflation, and investing in agricultural commodities or stocks can help offset rising living costs.
Real estate:
Real estate is considered an inflation-proof asset class because property values and rental income tend to rise with inflation. As the cost of living increases, so do rents, providing a steady stream of income that adjusts to inflation.
  • Direct real estate investment: - Owning physical property allows you to benefit from both property value appreciation and rising rental income.
  • Real estate investment trusts (REITs): - REITs offer an easier way to invest in real estate without owning physical property. They tend to perform well during inflation as they generate income through rising property values and rent payments.
Inflation-linked Bonds:
Inflation-linked bonds are government-issued securities that adjust for inflation. The interest payments on these bonds rise with inflation, ensuring that your real returns (after adjusting for inflation) remain positive.
  • Treasury inflation-protected securities (TIPS): - In the U.S., TIPS are a popular inflation-linked bond. Their principal value adjusts with the Consumer Price Index (CPI), protecting investors from inflation.
  • UK Index-linked Gilts: - In the UK, these gilts offer similar protection, with returns tied to the Retail Price Index (RPI).
Stocks in essential industries:
Certain stocks tend to perform better in inflationary environments, especially those in sectors that produce essential goods and services, such as:
  • Consumer staples: - Companies that produce everyday necessities (e.g., food, beverages, and household products) can pass rising costs on to consumers, maintaining their profitability.
  • Utilities: - Utility companies often have pricing power, allowing them to adjust rates in response to inflation. As a result, utility stocks tend to hold their value during inflationary periods.
  • Healthcare: - Demand for healthcare remains steady regardless of inflation, making this sector more resistant to rising costs.
Inflation-resistant equities:
Some companies have the ability to pass on rising costs to consumers through price increases, allowing them to maintain or even grow their earnings during inflationary periods.
  • Dividend-paying stocks: - Companies that consistently pay and increase dividends, particularly those in stable industries, often provide a hedge against inflation. Dividends can offer income that keeps pace with rising costs.
  • Growth stocks: - Companies with strong growth prospects can often outpace inflation as their earnings grow, although growth stocks can be more volatile in the short term.
Cryptocurrencies:
While still relatively new and volatile, some investors view cryptocurrencies like Bitcoin as a potential hedge against inflation. Proponents argue that since Bitcoin has a fixed supply, it is immune to inflationary policies like money printing. However, cryptocurrencies can be highly speculative and are not traditionally considered inflation-proof.
Collectibles and tangible assets:
Items like art, antiques, and collectible cars can retain or increase in value during inflation because they are scarce and often viewed as stores of value. While these assets are less liquid, they can provide a hedge if properly managed.
Conclusion:
While no asset is completely immune to inflation, diversifying your portfolio to include inflation-resistant asset classes like commodities, real estate, inflation-linked bonds, and stocks in essential industries can help protect your savings and investments.
The key to weathering inflation is a balanced approach that spreads risk across different asset types, ensuring your money maintains its purchasing power even when prices rise.
7. Inflation calculator
Try our simple to use calculator to calculate inflation between two time periods and understand the equivalent savings rate you would need to earn each year to keep up with it. For greater functionality try our stand-alone inflation calculator.
Simple calculator:
Show me how much:
In:
Is worth in:
Value adjusted for inflation:
What does this mean?