Inflation refers to a general increase in prices in relation goods and services that you buy. Inflation essentially increases the cost of living, measured by the Consumer Price Index (CPI).
Within the UK, Inflation is measured using the CPI which tracks the prices of a large number of goods and services (from bikes to video games). This measurement is released on a monthly basis by the Office for National Statistics and is indicated as a % figure. A figure of 2% is generally seen the benchmark to maintain the economy.
There are numerous concepts as to why inflation happens; it could be due to much money being in the economy, increases in demands for good and services or a weakening of currency which means imported materials cost more.
The link between inflation and interest rates
Inflation and Interest Rates are closely linked. When the Bank of England sets the base rate of interest (the benchmark for interest rates), it carefully considers the rate of Inflation. If inflation is too high because there is too much money being spent in the economy, it may look to increase interest rates to encourage saving and make it more difficult to borrow money.
If inflation falls below 2%, it may look to encourage spending within the economy by cutting interest rates – this will limit the appeal of saving and make it easier to borrow money.
When it comes to your investments & savings, there are knock-on impacts. Let’s take a look at a few examples as to why.
Your savings; let’s assume the best savings account on the market offers 1.5% interest (and that’s very generous). If the Rate of Inflation is at 2%, your ‘real return’ or on your cash is MINUS 0.5%. The reduction in spending power that Inflation has on your savings and investments is the ‘real return’.
Why investing in shares becomes much more appealing with low interest rates
This is why investing becomes much more appealing with the potential for far greater returns. One of the benefits of investing in shares is that companies can often pass on the rising costs to consumers, meaning their performance can remain intact despite inflation. Some sectors such as Telecoms arguably benefit more from Inflation as consumers are less likely to deflect due to the nature of the service.
Investing in bonds at times of high inflation is also less appealing. With a rise in prices, the real return of income from a Bond is diminished – because they original interest rate to be paid back to you will not buy you as much as originally anticipated.
Understanding the impact of Inflation is helpful to get to grips with what the expected income will be worth in the future of your investment. When it comes to saving, it also highlights why the minimal interest rates on offer at the moment could put you into negative territory at the end of your term.