This month inflation in the UK rose once again from 2.1% to 2.5%, almost reaching the 10-year high of 2.8% in October 2017. On the face of it, this might not seem that interesting given that a) 0.4% doesn’t sound like a lot and b) inflation is inevitable anyway, isn’t it?
In this article, I’ll explain a bit more about what inflation actually is, how worried you should (or shouldn’t) be about it and what it means for your money.
What is inflation?
In simple terms, inflation is the rate at which the price of goods, and services, are rising. If a loaf of bread cost £1 a year ago, and that same loaf of bread is now £1.10, the bread inflation rate is 10%.
The actual UK inflation rate is indicated by the Consumer Price Index (CPI) and compares the costs of a “basket of goods” over time. This “basket of goods” is tracked by the Office of National Statistics (ONS) and currently contains over 720 goods and services, which are regularly updated. This year, for example, electric and hybrid cars, hand hygiene gel and smartwatches were some of the additions.
Low levels of inflation may not be noticeable, particularly when buying low-cost items. However, you may notice a difference in bigger purchases, like your weekly shop. Inflation can also have a big impact in the long term, and these price rises can affect how much you can buy with your money.
An example of inflation that you will almost certainly have seen spoken about before is the price increase of a Cadbury’s Christmas selection box classic, the Freddo. Costing just 10p back in 1999, a Freddo can now set you back 30p; a 200% increase!
While Freddos have clearly increased in price far beyond the rate of inflation (it should cost ~18p if it followed inflation), it’s a good example of seeing how the price increases of goods can affect your buying power. Your 10p today isn’t going to satisfy that chocolate craving like it would back in 1999.
What does inflation mean for your money?
Keeping your money in cash, whether in current or savings accounts, has always been considered a safe bet. There’s no chance of losing money, and you can expect steady, but small, gains from interest.
In truth, keeping your money in cash has its own risk – “inflation risk”. But it’s not as easily seen, as you can’t readily see how the “real” value of your money fluctuates with inflation.
Let’s say you have £2,000 that you save evenly across two bank accounts:
Account 1 is a current account that offers no interest.
Account 2 is an easy access savings account with a 0.5% interest rate (about the best you can find in the market right now).
If you don’t deposit or withdraw any cash from either of these accounts, in a years time, the balances will be:
Account 1 – £1,000
Account 2 – £1,005
While it may look on the surface that your balance is steadily on the rise, if we were able to see the effects of inflation, we could see the real change to the value of our money.
Continuing on from the same example, let’s say that inflation over the last year has been 2.5% (the current rate in the UK). After a year, the actual value of the saved money, compared to when it was deposited, will be:
Account 1 – £975
Account 2 – £980.50
If you want to work out the inflation-adjusted return for your savings, use the following formula:
Inflation-adjusted return = (1 + Return) / (1 + Inflation) – 1.
So in the earlier example, the calculation is (1.005 / 1.025) – 1 = -1.95% A -1.95% return on £1,000 is £980.50.
Investing to beat inflation risk
We don’t know what the future holds, but given the current climate, it’s fair to assume that interest rates won’t be shooting up anytime soon.
You may be asking yourself if bank interest rates are currently five times smaller than inflation, how can you stop your money from losing value?
In short, the answer is to make sure that your returns 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. The risk associated with investing is however much 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.
Going back to our earlier example, let’s say that your friend has the same amount of money as you, £2,000. Instead of spreading this across a current and savings account, they decide to invest their money into an S&P 500 Index tracker fund (essentially tracks the performance of 500 large US companies). In 2020, the S&P 500 returned 15.76%, meaning that their £2,000 would be worth £2,315 after a year. We don’t even need to do the inflation-adjusted calculation here to know that your friend hasn’t lost value on their original money.
What can I do?
The state of play in this current financial climate means that any money we hold as cash in even the highest paying savings accounts, our money will lose value over time in real terms due to inflation.
This shouldn’t be too much of a concern for the money we plan to spend in the short term or need to have easy access to in case of an emergency (our emergency fund). But it’s much more problematic for our long term savings. The only viable way to tackle inflation is to sensibly invest our long-term savings, which will not only maintain but likely grow the value of our savings over a period of time.
Whilst investing comes with its own risks, there is so much available on the market now that will allow you to invest based on your own goals and risk appetite. Provided you invest for the long term, you can actually use investment risk to your advantage.
For your long term savings pots, which you don’t plan to use for a minimum of three, and ideally five-plus years; you should consider how you can invest this sum.
If you want to learn more, read Claro’s guide on how to get started investing.