MMP015: Inflation Explained [Podcast]
Here we are at session number 15 , and we’re going to be talking about Inflation. Todd Tressider of financialmentor.com describes inflation like this:
“Inflation is an incredibly dangerous three-headed monster: it can’t be forecast accurately and it multiplies your spending, while reducing average investment return”
I’m going to look at this dangerous monster in detail, show you what you need to know about it, and then what you can do to minimise its impact.
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Inflation is one of those things that we’re kind of aware of, but only in a loose sense. We hear the monthly inflation figures announced on the news each month, and we know it has something to do with the Bank of England and with interest rates. We may even remember our high school history lessons about the Weimar republic and people pushing wheelbarrows full of bank notes to buy a loaf of bread. Or maybe more recently we think of Zimbabwe, but that couldn’t happen to a modern, established economy lie ours in the west could it?
Well it could, but it probably isn’t likely, but inflation is a problem, and sometimes a benefit, to all of us. Let’s define it first:
“A rise in the general level of prices of goods and services in an economy over a period of time” – Wikipedia
So things getting more expensive is inflation at work. You could turn this on its head and say instead that you can buy less with your money each year that goes by.
Here's an interesting interactive chart thingy at The Guardian website
Pretty much every area of your personal finance is affected by inflation so it’s important that you know how it works, how it is measured, and steps you can take to minimise its impact throughout your life. That said, I’m not an economist, so this will be the practical stuff, rather than the theoretical – I hear you breathe a sigh of relief!
So, let's deal with everything you need to know about inflation and its impact on your finances
Everything you need to KNOW
I’m going to use Todd Tressider’s quote from the beginning of the session as a hook for these three things you need to know:
1 – Inflation can’t be forecast accurately
Inflation is measured in the UK by the Office of National Statistics. Every month, they release the official inflation figures. They measure inflation by monitoring the prices of a basket of goods and services. This includes lots of things that people buy:
- Restaurant meals
- Fuel – electricity and gas
- New cars
- Private school fess
- Even the price of a hamster
Here's a link to the current document showing what’s in the basket if you’re interested – nearly 700 items! The prices of all these things are measured each month and compared with the same month a year ago, and the difference is inflation. The two main measures of inflation in the UK are CPI – consumer prices inflation – and RPI – Retail prices inflation.
All the things in the basket behave differently, price-wise. So electrical equipment usually goes down in price. Think how much a 50” TV was just a couple of years ago – now you can buy them at supermarkets. Food: a bad harvest might push prices up or a good harvest push things down.
It doesn’t take much to make things unpredictable though – take the Japanese tsunami and subsequent problems at the Fukushima nuclear power plant – this disrupted electronics shipments for a while and pushed prices up.
In the year I was born – 1975 – RPI inflation was at 26%. The current measure of inflation, CPI is at 2.7% as I speak, one tenth of that earlier level. Inflation has even dropped negative on a couple of occasions in the last 60 years, most recently in mid-2009.
So it is tough to predict and difficult to control. There are many, many factors which affect it and holding them together to keep a rein on inflation is an impossible job, which is currently the remit of the Bank of England.
This difficulty in forecasting makes a difference when you are engaging in financial planning. The further into the future you look, the bigger the impact of inflation (more in a minute) and the more difficult it becomes to predict.
2 – Inflation multiplies your spending
Inflation says that a loaf of bread will cost more next year than it does today. Are you going to eat less bread? Probably not, so you’re going to need to spend more on bread next year than you do now.
But you’re probably not unduly worried about that, right? That’s because if you’re working, generally speaking earnings rise faster than inflation. If you’re a nurse or a policeman, you’re probably shouting at or stamping on your iPods right now listening to this, because you’re experiencing pay-freezes and what I just said isn’t currently true for you. But generally speaking, earnings rise faster than inflation. So if our pay is rising faster than inflation, we can pay the extra money for our bread, or our diesel or our holiday or whatever, and have a bit more to spare, so we feel a little bit richer than we did last year. Maybe we buy a bit more bread to celebrate?!
What happens if you’re on a fixed income though? Many pensioners who take benefits from their personal pensions opt for a level income – one that stays the same for life. The reason they do this is because it gets them more income now than they would have if they chose an increasing pension. We covered this a little bit last time in session 14. But I do wonder if they might come to regret this 15 years into their retirement. The State Pension does increase, as do many company pensions, so maybe this mitigates things a bit.
You can use a general rule of 7% here. The rules says that if something increases at 7% per year, it will double every ten years. So if inflation is running at 7%, something costing £100 now will cost £200 in ten years’ time.
7% is a bit high looking at inflation at its current level. So if inflation is running at 3%, say, it would take 23 years for something to double in cost. Or to put it another way, the buying power of a level income will halve in 23 years.
That might not sound too bad, but consider this: In retirement a greater proportion of your income will be spent on food and fuel, and these prices have been growing faster than the general rate of inflation.
So inflation multiplies your spending, and the impact of that is greater in retirement than it is if your earnings are going up faster than inflation.
3 – Inflation reduces average investment returns
This is a fairly simple concept to get across. Let’s say inflation is at 3% and you put your money in the bank at an interest rate of 3%. Ignoring tax, the interest you get has covered the impact of inflation. So if something costs you £100 today, and in a year’s time it costs £103, the interest you have got has covered the rise in price. So you can buy the same thing next year as you can now. In other words, you have stood still.
This has consequences when investing. Put simply, you have to make more money than inflation (and costs) in order to be better off at all. The higher inflation is running, the harder your money has to work just to stand still. Right now, with inflation at 2.7% and the average one year fixed term savings account at about 2%, you are actually losing money by putting it in the bank. People worry about losing money in the stock market, but if I told you that you were guaranteed to lose money every year by doing nothing, that’s a risk not many people think about.
When you are engaging in long term planning for your finances, hopefully you can see that inflation is a big factor. You have to plan for it. Make some assumptions and look at some worst-case scenarios. What if inflation jumps to 7%? What impact will that have on your future? If you’re comfortable investing in such a way that should yield returns of 5-6% per year, what happens in inflation gets near that figure. Are you prepared to take more risk to keep ahead of inflation?
These are questions you must answer when organising your finances. It’s not enough to just aim for a given investment return. It must be in the context of inflation over the long term.
So, to summarise what you need to KNOW:
#1 – Inflation can’t be forecast accurately – it is inherently unpredictable. (Some people much smarter than me might take issue with that)
#2 – Inflation multiplies your spending – by its very definition
#3 – Inflation reduces your average investment returns – so your money has to work harder, just to stand still
Everything you need to DO
So what do you need to DO to be prepared for inflation and its impact on your finances?
1 – Don’t live to the extent of your income
Easier said than done, I know, but spending less than you earn gives you some protection against rising prices. If you are spending every penny that comes in, and prices go up faster than your income, you’re going to start hurting.
It’s a universal principle that spending less than you earn is the only way ever to be financially secure. The surplus over your income can be saved – listen to session 5 on how to start saving.
You could also start shopping more intentionally. Maybe, if something is cheap and will last, stockpile it a little bit. In reality, most people won’t do this, and if I’m honest I don’t either. I do think life is a little short for obsessing over every single penny. That said, smart spending and saving is at the root of financial success. Also check out podcast session 3 on how to budget.
2 – Account for inflation when investing
I mentioned this briefly when I talked about investing earlier, but when you are considering how to invest, you need to bear in mind the impact of inflation. It’s just another factor to hold in tension with other things, like your timescale, your appetite for investment risk and so on. But it’s important.
When looking to the future, you need always to express monetary figures in today’s money. So if you are 25 now and earning £20,000 per year , you might think that retiring at 65 with a pension of £20,000 per year would be great. But in reality, if inflation runs at 3% for 40 years, that’s a little under a third of your current income, at £6,131 per year in today’s money – could you suffer a two-thirds pay cut right now?
Most financial institutions will produce illustrations and forecasts in today’s money, just make sure you’re looking at the right column. And whatever your plans for your pensions, investments etc, make sure you have taken inflation into account. Certain asset classes, like Gold and inflation-linked bonds can be really useful in combating inflation. Also, be sure to use all your tax allowances by investing in ISAs and pensions.
Don’t ‘lose money safely’, by keeping money in the bank and letting inflation and tax erode your money. Invest properly to give yourself a fighting chance of moving forward instead.
3 – If you are retiring, take extra care.
I’ve already said that inflation has a bigger impact on those in retirement than those who are working, primarily due to the fact that many pensions do not keep pace with inflation.
Make sure that when you are planning your retirement, you take account of which of your incomes are indexed (rise each year by inflation or a fixed amount) and which are not. If some or all of your pensions are level, you are going to be getting an effective pay cut every year for the rest of your life. Hopefully you have capital assets other than your pensions that you can dip into to supplement your income, and those are sufficient to last the rest of your life.
Cashflow modelling, that I mentioned briefly last time is the process of forecasting your financial future. Taking inflation into account is a big part of this process – see a Certified Financial Planner if you want this done right.
Hopefully you can see that inflation is a big factor to take into account. It’s just one of many factors, but an important one nonetheless. With some careful planning though, you can work around inflation effectively enough. The biggest danger is ignoring it. Most people do this out of ignorance, but you no longer have that excuse after listening to this!
That's it for this session of the MM podcast, I hope that was helpful.
Did I miss anything? Do you have any tips or tricks that work for you? Any questions? Please leave any comments or questions below, and I'll do my best to answer them.
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I hope you enjoyed this session. Next time we'll be talking about Risk – Interview with my friend Richard Allum who knows a thing or two about the subject.
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Thanks for listening – I'll talk to you next time