Inflation – what the saver needs to know

In the current economic climate, inflation has been a big problem for people with savings and investments, taking a large chunk out of the purchasing power of their money.

Things might be looking up a bit now, but the fact remains that to save and invest effectively you need to understand inflation and what it means for your financial planning.

What is inflation?

Inflation is when money loses value over time. It’s happening constantly – things are generally more expensive than they were a few years ago.

To see it happening, think about what you could buy with £1 over the past few decades. We’ll look at it in terms of loaves of bread.

1970: £1 = 10 loaves of bread

1980: £1 = 3 loaves of bread

1990: £1 = 2 loaves of bread

2010: £1 = 1 loaf of bread

So, £1 can buy you much less now than it could in 1970 – and in another ten years it will buy even less. This is due to inflation. This is known as the “purchasing power” of money.

High inflation and low inflation

If you hear that the inflation rate is high, that means you can buy less for the same amount of money, and this reduction in buying power is happening at a higher speed that usual. Inflation is measured as a percentage.

  • If the inflation rate is 1% (lower inflation) the purchasing power of money will be 1% less a year later.
  • If the inflation rate is 5% (higher inflation) the purchasing power of money will be 5% less a year later.

In December 2013 – the latest month for which figures were available when this article was last updated – the inflation rate was at 2%, down from 2.1% the previous month (Source: BBC).

Want to know what the inflation rate is right now? You can usually find it on the homepage of the Bank of England website.

What does inflation mean for you?

It’s important to know the inflation rate when you’re thinking about savings and investments, since it makes a big difference to whether or not you make a profit in real terms (after inflation).

Say you put your money in a bank account that pays you interest at 2%. A year later you’ll have 2% more money. But what if inflation is more than 2%? In that case, although you’ve got more money, it can purchase less than the amount that you began with

If your goal is to make money on your investment, you need to find an account or investment that ‘beats inflation’ – i.e. the interest or profit you make is higher than the inflation rate.

Should you try to beat inflation?

Depending on your circumstances, you might or might not want a product that beats inflation.

This is because generally, to receive higher returns, you may need to take more risk. If it’s very important to you that you keep your money safe, you might want to go for an account with lower interest, and grow your savings just by adding money every month.

To know what’s right for you, it helps to think through your savings goals. As a general rule:

  • for short term goals where you plan to spend the money within five years it’s safer to go for a savings account and not worry too much about inflation
  • for long term goals you need to keep inflation in mind when you invest

Setting your savings goals

Savings goals are the things you want to achieve in future, whether it’s buying a new car, saving for retirement or sailing around the world. Once you’ve set your goals, you can work out how to achieve them – some will be suited to long-term investments, some to short-term savings.

How to protect against inflation

Did you know?

In both 2008 and 2011, inflation climbed to over 5% – bad news for savers. But by shopping around you can find the best deal for your savings and reduce the impact of inflation.

Some savings accounts and NS&I savings certificates are index-linked which means that they will pay interest that tracks inflation but won’t always keep up with other interest rates. Investors can buy government bonds (gilts) that are index-linked. These get more expensive when the markets are expecting inflation to rise so the overall return may not beat inflation.

There’s no sure way to protect your money from the effects of inflation. The only rule is that cash savings accounts are generally the worst places to put your money long term – the interest is almost always lower than inflation, so you’re constantly losing money.

Savings accounts still have their uses, especially for money that you’ll need to get your hands on in the near future. But if you’re planning to put money aside for five years or more, it may be better to invest.

From an investment point of view bear in mind that conventional gilts and corporate bonds can be hit hard by inflation as both the fixed interest payments and the par value are eroded. Whereas with shares, dividends may keep pace with inflation.