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What is inflation?
Inflation measures how things you buy get more expensive over time, which means the money in your pocket gradually loses value. Let’s say the rate of inflation is 3% annually. This means that at the end of the year, it will cost £103 to buy the same amount of stuff that cost £100 at the start.
Imagine you stuck 73p in a piggy bank in 1982. Thirty years later you return to find that you still have 73p in your piggy bank. In financial jargon, the nominal amount remains the same. The only problem is that inflation has been nibbling away what that money can buy.
Back in 1982, 73p would have bought you a box of a dozen eggs. Thirty years later you could expect to pay £2.82 and 73p would only buy you three eggs. So you need to spend nearly four times as much to get the same result. The real value of the money in your pocket – its purchasing power – has declined over time.
How you measure inflation
As time passes, lots of things can get more expensive - a cup of coffee, say. But they don’t all get more expensive at the same rate. Some things might even cost less this year than they did last.
The official inflation statistics are based on an imaginary basket of goods and services that an average person (or family) buys. Prices for individual items – from milk to petrol to shampoo– are tracked and measured. Each month statisticians work out how much more expensive this imaginary shopping basket has become over the preceding 12 months.
Over time, the contents of the basket are revised to reflect changes in what people spend their money on. For example, the ‘amount’ of tobacco in the basket has reduced over recent years as smoking became less widespread.
So, the inflation figure is a generalisation and may not reflect your personal experience precisely. It all depends exactly what you spend your money on. Moreover, there are different measures of inflation such as the CPI and RPI. They differ in having different baskets of goods and services, but the general idea is the same.
Why does inflation matter?
It’s important to work out how your savings are getting on in real terms – after you’ve taken account of inflation – rather than just the plain (nominal) figure, which loses purchasing power over time.
A Cash ISA with an interest rate of 4% might sound good. But if inflation is running at 6%, you’re still losing 2% in real terms each year and your purchasing power is decreasing.
A 2% Cash ISA rate sounds less attractive at first glance. But if inflation is only 1%, you’d be making 1% in real terms each year.
In other words, the interest rate you’re getting doesn’t mean much unless you compare it with the rate of inflation. In recent years, savers have been hit as interest rates fell. Between 2007 and 2012, the average Cash ISA rate stood 2% below inflation, meaning that the real interest rate was negative.*
Savings rates vs. inflation (CPI)
The spectre of inflation
It’s all very well having £1m in the bank, but if that £1m only buys a cup of coffee you wouldn’t be so happy.
This may sound absurd, but in the past some countries have suffered hyper-inflation and people found themselves pushing around wheel-barrows full of banknotes because cash has simply lost its value.
Thankfully, in the UK inflation doesn’t seem to be running out of control at the moment. Nevertheless, even at much lower rates, inflation has a corrosive effect on savings - especially over the long term. Over the past 50 years, UK inflation has averaged 5.9% a year.*
The Money Advice Service says: “cash savings accounts are generally the worst places to put your money long term – the interest is almost always lower than inflation, so you’re constantly losing money.”
So how can one combat the effects of inflation? Some government bonds (gilts) are index-linked. This means the income they generate is relative to the rate of inflation. But this doesn’t mean returns will necessarily be higher than inflation.
In fact there is no sure way to beat inflation, but it’s one of the reasons why people choose to invest in assets like shares and property. The Money Advice Service concludes “if you’re planning to put money aside for five years or more, it may be better to invest.”
However, investing in stocks & shares opens the possibility of losing money and taking out less than you put in.
Also, there is nothing inevitable about inflation. Some economies (notably Japan) have suffered deflation in recent years. In this situation, the cost of goods and services actually goes down over time. This means that in a deflationary economy, holding on to cash has clear advantages.
* Source: Bank of England inflation calculator, 1962 to 2012
See how inflation has worked over the years, all the way back to 1750.
Bank of England
Monthly inflation figures show how much prices have risen for an average person - but what if your spending patterns are different?
"This inflation calculator will help show you how the value of your savings can be wiped out by sitting in a bank account that pays no interest."
This Is Money
Monthly CPI and RPI figures charted.
"In the current economic climate, inflation has been a big problem for people with savings and investments, taking a large chunk out of the purchasing power of their money."
Money Advice Service