The effects of inflation – and how to combat the latest rise

November 2017 saw inflation hit 3.1%; the highest it has been since 2012, as reported through the Consumer Price Index (CPI).

As 2018 gets underway, thousands of households will be feeling the squeeze and looking for ways to combat the shrinking value of their income or capital.

What is inflation?

According to the Office of National Statistics (ONS), inflation is The rate at which the cost of goods and services rises year on year.

Over time, goods and services increase in price, if income and capital fails to grow at the same rate, household budgets can feel tighter as a result.

Inflation cannot be avoided, it is a necessary factor in any successful economy. The resulting increase in demand for products and services drives production and manufacturing, which ensures that there are enough jobs and that people can afford to live.

As individuals, we can’t impact the rate of inflation. However, it is necessary to monitor the rate at which it is increasing, as this is what will affect our living standards.

The Consumer Price Index (CPI) measures and reports the rate of inflation. It does so through fluctuations in the price of everyday products. It does not show the effects on individual markets, but it does offer a great overview of the cost of living for an average person or household.

Consider everything you buy throughout the year; from food staples, to clothing, holidays and hobbies. The CPI works by comparing the total cost of the products and services year-on-year.

The effects of inflation

As inflation rises:

  • The cost of living increases
  • Interest rates could potentially rise
  • Capital is de-valued; and so is your income
  • It becomes more difficult to make big purchases
  • The value of your savings is eroded

When inflation rates are high, almost everyone is affected in some way. However, different groups see different outcomes, for example:

  • Savers: If the interest rate is lower than the rate of inflation, the real value of savings will decrease. Therefore, savers, who are more risk averse by definition, could very well experience the one thing they are trying to avoid; a loss of capital value.
  • Annuity holders: An Annuity provides a guaranteed income for the rest of your life, and potentially, your spouse or partner’s. When bought, the consumer is able to choose between a level or Index-linked product. Level Annuities are the most commonly purchased. As the cost of living rises, a pensioner receiving a flat pension income may find it harder to meet their financial needs over time.
  • Employees: If your pay rises are not in line with inflation, the buying power of your income is diminished. This, combined with the rise in interest rates, designed to offset the effects of inflation, can put a squeeze on household budgets.

Offsetting the effects

Combatting the effects of inflation is an ongoing battle. However, with careful planning and by staying informed, you can remain financially stable. Nine things you can do to help yourself are:

  1. Shopping around for the best savings account: putting in the effort now could save you a lot in the long term, as well as helping you to maintain the value of your capital.
  2. Hold savings tax efficiently: utilising products which allow you to collect the returns tax free, will mean that you see more of your returns than if you had to pass some of the interest on to the taxman. Cash ISAs are the best example of these. Use your Personal Savings Allowance (Up to £1,000 of interest tax free for basic-rate taxpayers and £500 for higher rate).
  3. Consider investing rather than saving: Over a longer term, investing has the potential to produce higher returns than saving. Of course, this comes with a risk to your capital and the value can fluctuate over time. However, currently saving accounts are almost guaranteed a real-term loss of value for your money. So, now might be the time to consider becoming an investor.
  4. Retiring: Fewer people are buying an Annuity when they retire, due to Pension Freedoms. However, if you do decide to purchase an Annuity, think long and hard about the effects of inflation.
  5. Budgeting: While inflation may not be having an immediate effect on your budget, if the gap between price rises continues for a long period, you will notice it. Therefore, preparing now will pay off in the long term. The price of living may be going up, but the best way to stay financially secure is to plan your finances in advance.
  6. Increase your income: Put yourself in as good a position as possible for pay rises, bonuses and other financial incentives which may be available from work.
  7. Build a safety net: Most experts advise having an emergency fund which could cover three months to one year’s living expenses. Having this in place gives you an added layer of financial security which will be extremely useful in the event of an emergency, illness or unexpected rise in the cost of living.
  8. Mortgage: Mortgage rates should be monitored constantly to ensure that you have the most competitive rate available. Interest rate rises are common when inflation is high, and that means a rise in monthly payments for tracker and variable rate products. Make sure that you can afford repayments if interest rates rise and your budget is squeezed further.
  9. Seeking advice: An Independent Financial Adviser will help you to make the most of your income. By getting to know you and your circumstances, they can point you toward the best products, methods, and budgets for you and your family.

For more information about inflation, or to discuss ways to protect your finances, contact us.