What is happening with inflation
Understanding inflation is an important factor when it comes to your financial success. If you don’t factor inflation in when deciding where to put your money – whether that’s savings accounts or investing – you could find your wealth shrinks over the years.
The current causes of higher inflation are largely COVID-related. The easing of lockdowns has boosted consumer confidence and unleashed pent-up demand. At the same time, bottlenecks in production and distribution are squeezing supplies – from building materials to foodstuffs. This supply and demand imbalance has forced up some prices.
The rate of inflation is the change in prices for goods and services over time. On 18 August, the Office for National Statistics reported the Consumer Prices Index measure of inflation saw a surprise slowdown in the year to July, down to the Bank of England’s target of 2% from 2.5% in June.
A sustained period of low inflation may have blunted some people’s concerns about inflation. But there’s now a growing realisation that high inflation could be around the corner, which reduces your purchasing power and what you could buy with your savings over time.
Some investors and savers may underestimate the damaging effects of inflation on their wealth. Keeping money in the bank typically earns interest, but if the interest rate is lower than inflation, money or purchasing power is effectively being lost.
People on fixed incomes – such as those whose pensions aren’t inflation-linked or workers on a static wage – are especially vulnerable to the effects of inflation. As living costs rise, your money doesn’t go so far.
Pension savers need to think about what their savings might be worth during retirement – often a long time into the future. Inflation can make the difference between an enjoyable retirement and a frugal, worrisome one.
That’s why you could consider mitigating the effects of inflation by investing some of your money in assets that aim to offer above-inflation returns.
Arguably, we can expect inflation to settle back to lower levels once the post-pandemic surge in demand has been sated and supply chains are smoothed out. But even so, with the global economy poised for a strong rebound, most central banks are keen to get back to ‘normal’ monetary conditions. So rock-bottom interest rates can’t last forever.
Bonds and other assets that pay a fixed income and/or a fixed investment return are especially vulnerable to inflation. Bonds become less valuable as inflation and interest rates rise, reflected in falling bond prices and rising yields.
Conversely, shares are generally a good investment during periods of modest inflation. A company’s fortunes typically track consumer demand and economic growth. If demand is strong, companies can raise prices, boosting the profits from which they pay dividends to their shareholders.
Besides shares, there are other assets with a track record of doing well during times of moderate inflation. These include infrastructure assets, where income streams increase as demand grows and the assets mature.
Likewise, gold and other commodities can be useful stores of value to hedge against inflation. So the good news is that it is possible to get an inflation-beating return on your savings, as there are different investment opportunities. However, these involve taking on more risk than with a cash savings account.