Inflation is one of the unseen forces of personal finance. It’s everywhere and it has a direct impact on your money in more ways than one. Most of us are only vaguely aware of it, but we need to understand it so we know what, if anything, we should do about it.
Everything You Need to KNOW
1. What is Inflation?
A good, clear financial definition of inflation is: “It is a general increase in prices and a fall in the purchasing value of money”.
It’s two sides of the same coin. On one, prices increase, and because of that, a static sum of money reduces in its buying power over time; that’s the second side to the coin. Neither sounds particularly positive, but that’s not quite the case.
How is inflation described? In developed economies there are accepted measures for inflation that work like this: Imagine a virtual shopping basket with a wide variety of goods inside, from big screen TVs to a loaf of bread, from clothes to train fares.
There are over 700 things in the basket, designed to be a representative cross-section of the kinds of things we Brits like to buy. The prices for these items are compared across lots of different suppliers and an average struck, and the value of the entire basket is added up.
The difference in the total value of that basket of goods from one year to the next is the increase, or decrease in inflation. It is expressed as a percentage, so if the prices increase from one year to the next by 3%, inflation is deemed to be running at 3%.
There are a few different measures here in the UK. The two main ones are the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). There are differences in what is in the basket in each case – RPI includes housing costs and is calculated as an arithmetic mean, and CPI is a geometric mean. CPI is the main measure for the government.
2. Inflation Works Against You
Inflation is generally seen as a bad thing, but there must always be some inflation in any healthy economy. The problems come when it rises too high or even gets completely out of hand.
In normal circumstances, inflation works against you as you build wealth in a ‘two steps forward, one step back’ way. For those of us saving and investing for the future, we like to see the value of our accounts increase over time due to asset price growth and our regular savings. What we don’t see is that a little bit of that growth is taken back off us due to the reducing buying power of that money.
Let’s say you want to buy something in a year’s time for £120 and you save £10 per month in a tin on your sideboard. After 12 months you go to the shop, but the item now costs £130, so you have to wait another month. Inflation has increased the price, so you either have to save more or get a better return on your money to buy in 12 rather than 13 months.
Remember, all financial planning comes down to income and outgoings. When you’re planning your retirement target, you will have a figure in mind maybe of a pension fund or ISA balance which can translate into a desired income.
But if you take inflation into account, you’re going to need more income than you might think, and hence a larger pot from which to draw. Not only does inflation reduce the growth rate of your money, it’ll also reduce the buying power of whatever money you end up with one day.
3. Inflation can Work for You
Just as inflation works against you when it comes to building wealth, it can work for you by reducing the value of your debt over time. If you bought a house back in 1968 for £18,000 with a £15,000 mortgage and interest-only debt. If you pay the interest each month but don’t pay down the capital, the outstanding balance remains at £15,000.
50 years later people borrow £15,000 to buy a kitchen, let alone an entire house. £15,000 doesn’t sound like a mortgage balance at all, does it? More like a credit card bill. Inflation has reduced the relative size of the debt by reducing the buying power of that £15,000.
While that mortgage has been serviced, wages have increased and prices have risen, so that £15,000 now feels like peanuts, though when the mortgage was first taken out in 1968, it would really have been a big deal.