Unless you’ve been living under a rock for the past year or so, you’ll have likely heard the word “inflation” thrown around a lot. But what is inflation? How is it measured? More importantly, why does it matter, and how does it affect you?
These are all questions I’ll attempt to answer below.
What is Inflation?
Inflation is a general measure of how much the price of goods and services change over time. It is calculated by comparing the price of individual goods or services from the previous year, to the current price. Price comparisons are done for thousands of items, and put together, forming a ‘basket’ of sorts. The average price change of all these goods and services is then calculated, giving us our inflation rate. This basket of goods is also known as the “Consumer Price Index”, or “CPI” rate.
There’s a huge range of goods and services included in the calculation. For example, hundreds of food and household items, various fuels (gas, oil, etc), used cars, financial services, hotels, and so on.
So, put simply, inflation is the average percentage change across all goods and services. Here’s a quick illustration to show what this looks like:
Types of Inflation
There are generally three ‘types’, or, more accurately, there are three important trends to be aware of. These trends are: prices rising on average (below ~3%), prices rising quickly on average (>3%), and prices falling on average (deflation). Let’s take a look at these three cases.
Positive Inflation
In this scenario, prices, on average, increase slowly year-over-year. While this sounds like a bad thing, it’s usually considered a positive. and is the sign of a growing economy.
However, as with all things, moderation is key. When prices rice too quickly, it can cause all sorts of issues for an economy. This has been evident in the UK in recent years, where inflation peaked at over 11%, creating a cost-of-living crisis across the country. More on this below.
Generally speaking, countries set a “target” inflation rate each year. For the UK, the target rate is 2% per year, therefore, any reading above 2% is considered potentially ‘bad’.
Negative Inflation
Here, prices decline on average, year-over-year. I.e., the inflation rate is below zero. Also known as “deflation”, this indicates a shrinking economy. While there are appropriate times where deflation is acceptable (e.g., following periods of excessively high inflation), it can have a catastrophic impact if it persists long-term.
Too much deflation, while seemingly good for consumers at first glance, can lead to severe recessions, even economic depression.
Deflation causes somewhat of a self-fulfilling prophecy. When consumers expect prices to continue to fall, their instinct is to ‘wait’ to get a better deal later. This in turn leads to lower demand for products or services, forcing businesses to lower prices even further in an attempt to retain customers and prevent bankruptcy. This can even spiral out of control, to a point where mass bankruptcies occur, pushing wages down; hence, pushing a country into a recession/depression.
High Positive inflation
When prices increase more than 4% on average per year, this can becomes a huge concern. If persistent, it often indicates an out-of-control economy.
To make matters worse, this situation is also open to a self-fulfilling prophecy leading to even higher prices. When consumers see prices rising quickly, they are more likely to purchase now, rather than wait for the good or service to become unaffordable. By doing this, consumers increase the demand for said product or service, allowing the business to increase prices further. This happened in almost every industry following the Covid-19 pandemic, due to consumers having more money, while businesses struggled with supply chain constraints, leading to higher and higher prices.
To make matters worse, when inflation is high, it’s often the case that wages do not increase at the same level. This increases the risk of the country’s standard of living being reduced. On the other hand, If rise faster than inflation, it could cause what is known as a wage-price-spiral.
Inflation In The UK
For August 2023, the UK saw a year-over-year inflation rate of 6.7%. The UK’s CPI was above 10% for roughly six months, only falling below 10% in April 2023.
In other words, when comparing UK prices on average, goods and services today cost 6.7% more in August 2023, than they did in August 2022. But remember, this is a ‘basket’ of goods, so items have increased more than 6.7%, while others have increased less. In some cases, prices have even fallen; but this has remained rare.
I should also mention that prices have only increased 6.7% since August 2022… August 2022’s inflation rate was 9.9%.
When you combine those two figures (109.9% multiplied by 106.7%), prices have risen around 17.2% since August 2021!
Unfortunately, it’s expected that wages will rise much more slowly than inflation overall. While this may prevent a wage-price-spiral, it does not bode well for poorer households, who are likely to be worse off in the long term. In fact, this has been illustrated by the recent strikes across both the public and private sector.
While this sounds concerning, there are plenty of positive signs that inflation is coming under control. The Bank of England expects inflation to fall rapidly by the end of the year, nearing 2% once again in 2024.
This, unfortunately, doesn’t mean prices will come down. It merely means prices won’t continue to increase as quickly have they have been. No doubt, some industries will see prices fall, though. Something we’re already seeing in the electric vehicle space, for example, thanks to cheaper batteries and improving supply chains. That being said, prices have also fallen to counter the incredibly high interest rates, allowing consumers to continue affording vehicle loans.
Why Does Inflation Matter?
So, why does this all matter to you?
Inflation influences your current – and future – “buying power”. In other words, it influences how much you can buy with each Pound you have available.
Using a loaf of bread as an example: let’s assume I can buy a loaf of bread today for £1.00.
Let’s also assume that the inflation for this loaf of bread remains at a rate of exactly 2% for the next 10 years. Then, in 10 years time, this same loaf of bread will instead cost about £1.22.
The price here has increased by 22%, rather than 20%, due to the compounding effect inflation has.
What if if inflation stayed at a higher rate? Let’s assume a rate of 9% for 10 years… Now, that same £1.00 loaf of bread would cost a whopping £2.22!
Looking at this in reverse, then, we can see that if we have £100,000 saved in a current account today, with a 0% interest rate, it will have much less ‘buying power’ in 10 years time. That same £100,000 will buy fewer of the same products than today. In fact, after 10 years at just 2% inflation, you would need around £122,000 to have the same ‘value’ as today.
This is why inflation matters. Because it can – and does- have a significant yet often unseen impact on your finances over the long-term.
What Can You Do To Beat Inflation?
Okay, so you now know how inflation can impact your finances over the decades. You’re probably asking yourself “how can I prevent my money from being eroded by inflation?”.
As seen above, saving money as cash (with no interest) may be a poor choice in the long-term. Even today, at a time when you can get an interest rate of 3%-4% at most banks, this is still well below current inflation.
Remember! It’s always a good idea to keep some money in an easily accessible account, in the form of an emergency fund. I’m talking about money outside of said emergency fund.
Those aiming to build long-term wealth tend to invest their cash in assets. For example: stocks, real-estate, bonds, etc. The hope here is to obtain a higher ‘yield’ on their money than the long-term average inflation rate.
Generally speaking, investing money into various assets has historically been an effective way to stay ahead of inflation, protecting your buying power in the long-term. Investors expect a return of between 4% and 10% per year on average, much higher than both the average interest rate and inflation rate. Naturally, these returns are not guaranteed, and a diversified portfolio is recommended.
Have you read this and want to consider investing? Then here are eight things you should do before investing. While the post linked here is designed for those wishing to invest in the stock market, the first five points are crucial regardless of what asset class you’re interested in.
