In December it was announced that the UK’s inflation rate was 5.4%, its highest level in a decade. This came as a surprise to the Bank of England, which had forecasted that inflation wouldn’t reach 5% until April 2022. With inflation outgrowing its forecast, it’s important to understand what inflation is and how it affects you.
What is inflation and how does it affect you?
Inflation describes the process by which our money loses real value as the price of everyday purchases around us increase. Inflation is calculated as the average increase in the price of a basket of goods and services within an economy.
The actual UK inflation rate is indicated by the Consumer Price Index (CPI) and compares the cost of a “basket of goods” over time. This “basket of goods” is tracked by the ONS and currently contains over 720 goods and services, which are regularly updated (hand sanitiser, smart watches and hand weights for home exercise have recently been added).
In real terms, a 5.4% inflation rate means that £100 worth of goods and services last year will cost you £105.40 today, meaning you would get less for your money today compared to last year. As the 5.4% rate is an average, the specific price rise in different goods and services will vary. As an example, Uber reportedly increased its prices in London this year by 10%.
There are a number of factors that are driving the inflation rate up, such as:
- Global supply chain issues pushing up product prices
- Surging demand for oil and gas causing higher energy prices
- Shortage of staff e.g. HGV drivers
- An end to government support e.g. reduced VAT for hospitality
As well as increasing the price we are paying for our outgoings, inflation has an impact on your income. Unless you receive a pay rise above 5.1%, you will essentially be experiencing a real term pay cut, as your income has less purchasing power than previous years.
What can you do?
The inflationary impact on your bottom line is quite subtle unless you scrutinise it more closely, but an increase of 5% on each of your transactions over the course of a year can seriously add up and derail you from achieving your financial targets. This is why it’s so important, now more than ever, to be much more intentional about your spending. It can sound daunting, but this doesn’t mean you should pinch every single penny, rather you should consider when spending your money whether it’s a beneficial, productive or impulse purchase – rather than spending mindlessly.
In addition to watching your spending, you can also invest to beat inflation. To stand the best chance of doing this, you should make sure that you are investing your long term savings (minimum 3-5 years).
Investing carries more risk than holding your cash in a current or savings account; the value of your investments could drop in value. Generally, the greater the risk, the greater the potential returns or losses. The risk associated with investing is however more nuanced, it’s not so much a lottery because there are a number of things you can do to reduce the risk of your investments losing value, such as:
- Invest for the long term: By keeping your money invested for a minimum of 3-5 years, you can ride out any volatility in the market caused by events like Covid. The longer you invest, the more chance your money has to weather any downturns and ultimately grow in value.
- Diversify your investments: Spreading your investments across multiple asset classes, sectors and geographies means that your risk is spread across a well-balanced basket or portfolio of investments. If all of your money is invested in a single company and that company has a bad year and loses 20% of its value, so has all of your invested money. You would figuratively be making the mistake of putting all of your eggs into one basket. If instead you are also invested in several other funds, companies and assets, your overall return won’t be so dramatically impacted if one of your investments isn’t doing so well.
The Bank of England may decide to increase interest rates in an attempt to tackle soaring inflation, however, this may not be effective if inflation is being driven by factors external to the UK, such as energy prices.
The logic behind this (a throwback for A-level economics alumni) is that increased interest rates mean that a) borrowing is more expensive and b) saving is more rewarding so people will buy and spend less, resulting in inflation dropping.
In the meantime, we can look to minimise the impact on our finances by being more conscious about our spending, and if you can afford to put your money at risk, by considering investing. If you do decide to invest please remember the value of your investments can go down as well as up.