What is inflation?

Most people have heard of inflation – it’s been hard to avoid it as we’re regularly seeing news reports of rates increasing to levels not seen for over a decade – but what exactly is inflation, and what does it mean for you?

What does inflation mean?

Inflation refers to the rate of general increases in the prices of goods (such as food and clothes) and services (such as haircuts and plumbers etc) and is calculated each month by looking at changes in prices of over 700 separate goods and services in the UK. This basket of goods is reviewed annually to reflect the changes in the things we buy.

The Bank of England’s long-term inflation target is 2% per annum. However, we are currently seeing a 5.4% rate of inflation.  What this means in real terms is that prices are 5.4% higher than they were a year ago, i.e., if an item cost £100 last year, it will now likely cost £105.40.

How does it affect my Financial Planning?

Inflation can mean different things to different people depending on whether you are looking to hold, buy or sell an asset/item.

If you hold large cash deposits, inflation can be a very real and pressing issue. This is primarily because the interest rates currently offered on cash deposit accounts simply can’t outpace the rate of inflation we are seeing at the moment.

In practice, this means that a cash account holding £100,000 may earn £250 in interest over the year (0.25%), but it still falls far short of the £5,400 (5.4%) increase needed just to keep pace with the current rising cost of living over the last year. This loss in buying power is deepened as the years go on resulting in your cash holdings not being able to purchase nearly as much as they would have been able to in the past.

Accounts that pay a fixed rate of interest such as fixed interest securities are worse-off too, as the interest paid out will be less valuable each year in terms of how much it will be able to purchase, though if interest rates were to rise and inflation decreased the situation would be reversed.

On the flipside, if you are entitled to receive the State Pension, your entitlement will increase each year in line with the ‘triple-lock’ – the lesser of inflation, the increase in average earnings, or 2.5% (please note the earnings element of the triple lock has been suspended for the 2022/23 tax year). This means the income you will receive from the State Pension is protected against inflation and may even exceed it in some circumstances. Another asset to consider in times of high inflation is a diversified portfolio of shares which can provide the opportunity for growth at a rate which exceeds the current rate of inflation and protects the ‘real value’ of your money.

Likewise, if you currently own your home, you may view inflation positively as its value is likely to increase as inflation rises. On the same vein, if you own gold or other assets of significance, their value will most likely increase with rising prices too, meaning that you will get more money from the sale proceeds than you would have if you had sold a year ago. Conversely, this means if you are looking to purchase any of these items, they will be more expensive to buy as inflation increases.

The range of ways different assets react to inflation highlights the importance of making sure your portfolio is spread across a range of assets which each perform well in different market conditions. We call this ‘diversification’ and it helps to ensure that negative performance in one investment will be offset by the positive performance of the other, otherwise you risk holding all your eggs in one basket that could come tumbling down if the economic conditions aren’t just right.

If you are concerned about the effects of inflation on your finances or would like to understand how you can improve the spread of your investments, please contact Kreston Reeves Financial Planning, part of the Craven Street Wealth group on +44 (0)330 124 1399, or complete our online enquiry form.

The content of this article is for information only and does not constitute formal financial advice. This material is for general information only and does not constitute investment, tax, legal or other forms of advice.

You should not rely on this information to make, or refrain from making any decisions. Always obtain independent, professional advice for your own particular situation.

Kreston Reeves Financial Planning Limited, Independent Financial Advisers. Authorised and regulated by the Financial Conduct Authority.