The Dangers of Inflation…

What is Inflation?

Inflation is the general increase in prices and the subsequent fall in the buying power of your money over time. Think about how much you could buy with £10 back in 1980 compared with how much £10 will buy you today. 

A lot of people say they used to earn, say, £5,000pa but at that time, a house probably only cost something like £50,000 so it’s all relative to a degree.

I remember a bag of Monster Munch (my favourite crisps at the time) was 12p!  One of the fondest memories I have of my childhood (joke!).

The main measures of inflation are:

  • CPI (Consumer Price Index):  Made up of a bunch of commonly bought goods and services, such as food, clothes, airfares, postage, etc.

  • RPI (Retail Price Index): Pretty similar to CPI, but also includes house prices and, therefore, tends to be higher than CPI.

  • CPIH (Consumer Price Index including Housing costs): This includes housing costs, such as council tax and other taxes. CPIH is also likely to be higher than CPI.

What Causes Inflation?

There are several factors:

  • Import prices: If prices of overseas goods and services go up and we, in the UK, want those goods and services, we have to pay more for them, which pushes up the prices. 

  • Tax rises: if taxes such as VAT go up, that also pushes up prices, as the cost is passed onto the consumer, which in turn pushes up inflation.

  • Employment and wages: if a country has a high level of employment and wages increase, this will feed through into higher inflation.

Interest rates are used by central banks to combat inflation. So, if inflation goes up, the Bank of England and other central banks around the world use interest rates to help manage it. It’s a blunt instrument but does tend to work.

The Impact on Your Money

Typically, if inflation goes up, the amount you need to earn from your invested money also needs to go up to account for inflation, otherwise, you’re effectively losing money.

This is particularly important if you’re taking an income from your invested money.  Both the level of income required and the annual returns necessary to sustain it should be adjusted to account for the anticipated level of inflation so there can be a bit of a double-whammy effect!

That said, it’s impossible to know what inflation will be in the future (or, for that matter, investment returns).  All we can do is make some common-sense predictions, largely based on what’s happened in the past.  Reviewing things regularly will tell us how wrong we were.

You might have heard the term ‘nominal’ return.  This is the growth you get BEFORE inflation is taken into account.  It’s the ‘real’ return that counts though because that factors inflation in.  So, if your investments grow at a ‘nominal’ rate of 4% but inflation is 6%, the ‘real’ rate of return is minus 2%.

Here’s a couple of charts that demonstrate things.  The first shows what would happen to £100,000 if you took out 5%pa from age 55 but this income didn’t go up with inflation:

The second chart shows what things would look like if you increased what you were taking from age 55 by 2%pa to take into account inflation:

It’s quite a dramatic difference so it’s something you need to be mindful of.  As we know, inflation is MUCH higher than 2% at the moment so it could be worse.

Managing how you take your income is VERY important.  If you’re lucky enough not to need to take an income from your invested money, that doesn’t mean inflation isn’t your enemy, it’s just worse when an income’s needed.

Don’t Panic!

Think of this little article as education and not fear-mongering.  Inflation, over time, goes up and down, like everything else.

The key thing to do is review it regularly so you know where your money is in relation to inflation.  Are you ahead or behind?  What do you need to do about it?

There’s never a magic bullet but, hopefully, most of you will know me well enough to know that this is the sort of thing I keep a close eye on for you.

I’m always here if you want / need to talk.  No question or concern is too ‘silly’.  I can’t guarantee a solution that will solve everything but I can guarantee a very sympathetic ear!

Speak soon!...

Marco