How does inflation affect savings - is it good or bad?
How does inflation affect savings - is it good or bad?
Whether you have saved money for a house deposit, to buy a car, to go on holiday or simply to act as a safety net for the future, your savings will always be affected by inflation. Putting aside cash into a savings account may feel like you are insulating yourself and your family from an uncertain future, but in times of rising inflation, your margin of safety could be rapidly eroded.
What is inflation?
We recently published an article on the basics of inflation and how it affects your salary and money, so be sure to read that first. In summary, though, inflation is the rise in prices of the things we buy every day and is measured by several indexes including the Consumer Price Index (CPI) and the Retail Price Index (RPI). In current times, the big UK Inflation news stories are the rising cost of energy to heat our homes, the increase in the cost of petrol and diesel and the looming spectre of increasing food prices.
What causes inflation?
As with most things related to economics, it can be quite complicated. In essence, though, an increase in the supply of money is what causes inflation. However, this can be divided into three main types of inflation:
Demand-Pull Inflation: Where there is more demand than supply.
Cost-Push Inflation: Where increased production costs increase prices.
Built-In Inflation: Where wages increase to cover increased prices.
Is inflation good or bad?
Whether inflation is good or bad wholly depends on what side of the argument you take and how quickly the changes happen.
For example, if you hold investments or assets that are priced in a currency such as houses, commercial property or precious metals, a moderate rate of inflation can be seen as a good thing because you will see the prices rise and you can sell them for a profit. Conversely, if you are trying to buy a similar asset, it can be increasingly difficult as the value keeps on increasing due to higher inflation.
If you hold cash, bonds or fixed-income assets, you will find inflation not to be in your favour as the purchasing power of these assets will decrease over time.
How can I protect my money and savings against inflation?
Investors looking to protect their wealth against the effects of inflation could consider assets such as property, precious metals and commodities as these may stand a better chance of increasing in times of inflation.
Another issue to consider is the spread between the net return of an investment and the inflation rate. For example, if the interest rate of an investment fund is 8% and the inflation rate is 9%, the purchasing power of your money will decrease by 1% each year.
If we consider the effect of inflation on your cash savings, if your savings account or cash ISA offers an interest rate of 1% and the inflation rate is 9%, the purchasing power and real value of your money will decrease by 8% each year. This may be acceptable for a couple of years, but in extended periods of high inflation, you can see how quickly your savings will be eroded. As such, it may be worth increasing the amount you are saving each month in an attempt to keep the purchasing power of your cash savings.
Be warned though, in times of a high inflation rate, it's common for businesses and investors to seek above-inflation gains by getting involved in higher-risk projects with promises of a high interest rate. These may be more risk than you would normally consider and could result in losses you can ill-afford.
What can governments do to reduce inflation?
In typical periods of rising inflation, a government's central bank can raise the interest rate of the base rate to kerb consumer spending. The theory is that an increase in interest rates will make borrowing (in the form of mortgages and loans) more expensive, which will promote lower spending. Conversely, if interest rates are reduced, borrowing may become much cheaper and therefore consumers are likely to buy more.
When is inflation a good thing?
When you already own an asset that increases in value with inflation.
If you hold an inflation-linked investment that increases in value with inflation.
If you have debt (such as a mortgage) as the amount owed will reduce more rapidly in real terms.
When is inflation a bad thing?
When you are trying to buy an asset that keeps increasing in value with inflation.
When you hold cash and the purchasing power evaporates over time.
If you have a fixed income product, such as an annuity or bonds with a fixed interest rate, it will be worth less in real terms.
When you are taking an excessive risk to try and recover from inflation-linked losses by seeking a higher interest rate.
When you have little disposable income and don't receive inflation-linked pay increases.
Conclusion.
Inflation is something that affects us all and to feel confident in the way we spend, save and invest, we need a stable rate of inflation. In times of higher inflation or variable inflation rates, consumers need to think very carefully about all their buying and selling decisions.
Don’t forget to read What is inflation and how does it affect my money? and you can also check our UK Salary and Wage Inflation Calculator to see how much your pay increase needs to be to keep pace with inflation.
Finally, you can read the Bank of England’s view on the current inflation rate in the UK.
What’s next?
If you need help or advice on your personal or business finances or if you want to consider investing to make your money work harder, you can get in touch with one of our advisors for independent financial advice. We offer a free initial consultation and although we are based in Tunbridge Wells, we advise clients across the UK.
Don’t forget, this article offers information about investing and should not be taken as personal advice. Remember that investments and pensions can go up and down in value, so you could get back less than you put in. Tax rules can change and the benefits depend on individual circumstances.