Answer:
Inflation is often referred to as a “measure of the increase in the price of goods and services over time”. Inflation not only affects the cost of living – things such as transport, electricity and food – but it can also impact interest rates on savings accounts, the performance of companies and in-turn, share prices.
As measures of inflation rise, this reflects a reduction in the purchasing power of your money. In other words, this impacts your ‘buying power’, as you’re now able to buy less with your money.
In the UK, there are two main inflation-rate measures;
the Consumer Price Index (CPI) and;
the Retail Price Index (RPI).
They look at different items and are calculated using different formulas. The CPI covers the cost of hundreds of items that households are likely to purchase – many on a daily or weekly basis – including things like food, clothing, cinema tickets, etc.
The CPI doesn’t take into account housing costs and mortgage interest payments, as this is included in the RPI measure. The RPI measure is used to index various prices and incomes, including tax allowances, state benefits, pensions and index-linked gilts. RPI has been superseded in recent years by CPI and is no longer formally ranked as a UK National Statistic.
Although we are unable to stop the rates of inflation, taking measures to protect your wealth could help to limit its harmful impact.
How will inflation affect my money?
When it comes to the cost of living, a rising inflation measure means it has become more expensive to maintain our previous lifestyle. If your income hasn’t increased over the measured period by at least the rate of inflation, then your buying power will have fallen, as the costs of goods and services will have increased over that time.
Inflation doesn’t just affect our everyday expenses, but could also impact our savings, investments and pensions.
Cash savers
Cash savers could be hit particularly badly, as the purchasing power of our money falls. Consider the following example: if you invest the amount needed to buy a car into a bank account for 5-years – at an annual interest rate of 1% – and the cost of cars over the same period increases by 2% per annum, then at the end of the period you would need to add more money to be able to buy the car.
Think about how the cost of living has already changed since you were a child. A high rate of inflation combined with a low rate of interest, means the money we have saved in potentially poorly performing savings accounts could be seriously hit, having a detrimental effect for cash savers.
If inflation, as is usually the case, is higher than interest rates, then in real terms your returns will become negative, meaning you may want to think about whether cash is the best place to stay in the long-term (for instance, high street savings accounts and cash ISAs.)
You could consider alternative methods for saving, such as investing in assets that have traditionally increased at a higher rate than inflation. Options could include considering investments that are inflation-linked, like some National Savings Accounts or government loans, investing in property, or in stocks and shares.
