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25/11/2021

Inflation: What is it, and what does it mean for your savings?

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Over the years, inflation has been a major issue for people with savings and assets, draining away a significant amount of their money's buying power. 

 

Over the years, inflation has been a major issue for people with savings and assets, draining away a significant amount of their money’s buying power. 

To save and invest effectively, you must understand inflation and its implications for your financial plan. Now that inflation has reared its head again in the UK, it’s time to talk about what it means for you.

In this article we’ll explore what inflation is, what causes it, and what inflation means for you and your family.

 

What is inflation?

As the name suggests, inflation is the name given to a process whereby prices for goods and services become inflated. 

When inflation occurs, all products and services that are affected will see price increases over time. These price increases often outpace the rise in income, meaning people can afford fewer items than they previously could with their pay.

If, for example, an item cost £100 six months ago, but inflation has caused it to rise in price to £110 today, then inflation has caused you to be able to buy £10 less with your pay packet than you could previously.

 

What causes inflation?

The reasons for inflation are many and varied, but the most common cause of inflation occurs when the supply of goods and services cannot meet market demand for them, or when there is a significant increase in the overall money supply. 

When there is an excess amount of money in the economy, people will naturally spend more on products and services than they otherwise would have, and if the supply can’t meet that increased demand, prices will increase.

This, in turn, means there is less inherent ‘value’ to the money that is in circulation. In simple terms, the same amount of produce will cost you more now than it did previously.

In the modern economy, inflation is measured through a Consumer Price Index or CPI, which measures changes in the cost of living for everyday goods and services. An increase in the CPI may signal that economic conditions are favourable, and that future price increases can be expected.

 

How did the COVID-19 pandemic impact inflation?

One of the most impactful inflationary periods in history occurred after the 1918 Spanish flu pandemic that killed nearly one-fifth of the world’s population. Hoarding of goods contributed significantly to price increases during this time. 

When the pandemic became public, there were concerns that during the outbreak supplies of food and other products would dry up. As a result, people began hoarding more of these items than they otherwise would have, and since demand far outstripped supply, prices rose.

We’re seeing something similar today in relation to the COVID-19 pandemic – demand for goods has greatly increased while at the same time supply chains are failing across the globe.

In addition, the rise of Government support schemes – like the furlough scheme in the UK and the COVID-19 stimulus scheme in the US – have injected more money into the global economy. These factors have combined to create a steep rise in inflation worldwide, which could be with us for some time yet.

How does inflation affect your savings?

Inflation will affect your savings by siphoning off some of your money’s purchasing power. 

If, for example, you put £100 into a savings account that pays 5% interest, after a year you’ll have £105, or 5% more money than what you put in.

When inflation hits, that formula doesn’t change. You’ll still have 5% more money, or £105 in savings. But if inflation rates are at 5% or more, then you’ll be worse off than you were before, even taking into account the interest you’ve earned.

That’s because inflation has outpaced your interest, meaning that £105 will buy you less than it would have done in the past.

 

What can I do to protect my savings from inflation?

Inflation is often a global problem, created by economic forces far outside our control. Once it hits, there may be little you can do to protect yourself from the rising costs, but there are a couple of things you can do to ensure you avoid the worst of it. 

 

Think about your long-term savings goals

Savings goals are long-term objectives, like putting money towards a home, saving for your retirement, or funding a once-in-a-lifetime trip around the world.

Only once you’ve established your objectives, whatever they are, can you figure out how to accomplish them. Some savings goals will benefit from long-term investments, while others will need short-term savings.

For shorter-term objectives, you may find inflation has a bigger impact on your savings, and the amount that money can buy.

That’s why it’s important to focus on long-term savings goals. By taking a long-term view, and not giving in to the temptation to ‘cash in’, you should be able to ride out inflation and see your money’s purchasing power rise again.

 

Be proactive

If, on the other hand, you decide it’s in your best interest to take measures to protect yourself against future inflation, then you need to be proactive. The time to prepare for inflation is before it hits, not after.

To avoid getting caught up in hyperinflation, take steps now to preserve your money and establish an overarching financial safety net.

First, you need to build up a ‘Break Glass’ savings fund that you can access at any time, with enough money to see you through a period of two to three months in case of an emergency

Once you’ve built up your emergency fund, you can start to think about what to do with the rest of your money. That’s when it may be time to consider investing in stocks and shares that are protected from inflationary pressures.

 

Invest wisely

Many people choose to invest their money in assets that are outside the reach of inflationary forces, including precious metals like gold and silver, commodities like oil and natural gas, or produce like grains or orange juice.

While it’s important to note that traditional investments are not without risk, and big losses do happen, investments can provide a safe haven for your money during times of inflation.

If you invest your savings wisely, it’s possible that those investments will help you ride out the inflation cycle with few problems, let you enjoy the benefits of your savings when the market ticks upward, and leave you in a better financial position down the road.

The most important thing to remember is that you should never consider investing without first doing your research, or seeking the help of a professional financial adviser.

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