Inflation - Friend or Foe

Why you need to be aware of the positive and negative effects of inflation

Inflation – Friend or Foe?

Inflation is something most of us are aware of and is something we unfortunately cannot avoid. Whether we like it or not it eats away at the spending power of the pound in our pocket without us really noticing. Sure, we all see the figures in the media but how many of us really know what effect it has? 

In the chart below are shown the annualised inflation rates for the last 25 years. Looking at each year in isolation this does not tell us a lot but cumulatively the effect on your spending power is relentless. For each £1 you spent in 1995, you would need to spend £1.80 today!

Inflation Rate Graph

What is meant by the term “purchasing power”?

When the costs of producing goods increases this will generally feed through into the economy in the form of inflation. An up tick in costs can arise from a number of different areas ranging from wages to the cost of transportation – oil prices might be on the rise for example which directly impacts what it costs to physically move goods from A to B. When this happens either the companies that are selling the product absorb those increased costs (which can’t go on forever) or the price of the product is increased directly impacting you as the consumer. In other words the pound in your pocket will buy less of the same product before the price went up. Your pound is still physically a pound but the purchasing power has been reduced.  

Why is inflation important?

When inflation increases other areas of the economy are affected as well – this can include interest rates and salaries for example. Higher take home pay means that consumers have a choice – either to spend or save. Choosing the option to spend increases demand, feeding back into the production cycle increasing the profits for the manufacturers and allowing expansion plans to go ahead. If the consumer saves the extra income they receive, this increases the money in circulation that the banks can use to fund other projects such as mortgage lending.

Should I be concerned about inflation?

The simple answer is yes. Over the last 20 years, taking into account inflation, your purchasing power has been shrunk by nearly a half. It is also worth bearing in mind that this has been during a time when inflation levels have been historically lower – for example in the 1970’s and 1980’s annual inflation rates regularly hit double figures.

Over the last couple of years, the annualised inflation rate has been extremely subdued, flirting with negative territory on occasion during 2016. However, following the BREXIT referendum and the pound falling in value (resulting in the cost of imports into the UK rising), the Bank of England has forecast that consumer price inflation is expected to rise to 2.7% by November 2017. In November 2016 this was recorded as 0.9%.

No matter what the inflation rate is, unless your savings are increasing at a similar rate the purchasing power of your money will reduce (see previous explanation). Where inflation begins to gain a foothold, central banks often use interest rates as a tool to keep inflation in check which is often of benefit to investors that have cash deposits or Cash ISAs. However, the Bank of England has already stated that they feel that due to the economic uncertainty created by the result of the BREXIT referendum that they have no plans to raise interest rates currently.

Protect your savings from the ravages of inflation

Whether you currently hold your savings in cash or in the stock market (or a mixture of both), ensuring that your purchasing power is protected is essential in enabling your financial goals to be met.

This website is not personal advice based on your circumstances. No news or research item is a personal recommendation to deal. Investment decisions in collectives should only be made after reading the Key Investor Information Document, Supplemental Information Document and/or Prospectus. If you are unsure of the suitability of your investment please seek professional advice.