Inflation: paddle boards and economics

This week’s blog comes from a sunny Dornoch, where I’m loving the early autumn warmth with the family, our trusty VW campervan and a new inflatable paddle board.

I must admit, the 12v electric pump for the paddle board is a superb accessory. Effortless and automatic inflation to just the right pressure, then we’re off to the beach.

I’ll bet the Monetary Policy Committee at the Bank of England wished they could have an automatic pump like this to inflate the economy to just the right level.

Like our paddle board, the economy needs just the right amount of inflation. Too much and it explodes, too little and it deflates, then sinks and we’re in all sorts of trouble.

But what does inflation mean for your personally?

Money in the Bank

Generally, inflation is not good for savers. In fact, it’s the main risk associated with what’s seen as a safe place for your money. The Bank of England base rate is currently at an all-time low of just 0.1%, so it’s a struggle to find savings accounts that offer anything worthwhile.

And although inflation has dropped to only 0.2% this month, the long-term trend is around 2% to 3% so your savings need to earn at least that to ‘stand still’. Your cash loses its buying power if inflation is higher than the interest rate you earn.

Over the long term, that can be catastrophic, so it’s important to understand at least the basics of investing into stocks and shares, whether that be through your pension, ISAs or other investments.

Investing time in your financial education now will help protect your future financial wellbeing.

Mortgages and Debts

The opposite is true for those who owe money to the bank. If you have a £100,000 mortgage now, even if you only pay the interest and don’t make payments towards the capital, the ‘real’ value of that debt will drop to £77,633 after 10 years, assuming a constant inflation rate of 2.5%.

So in the long run, inflation can help to erode the value of outstanding debt. Of course, you still need to pay interest on those debts, but with a base rate of only 0.1%, borrowing is cheap at the moment.

What’s the Bank of England got to do with it?

Monetary Policy is one of the government’s methods of controlling inflation. Basically, the idea is that inflation can be influenced by changing interest rates, amongst some other more complicated techniques, but the main thing is that the Bank of England is targeted to keep inflation at around 2%.

The latest figures show that the Consumers Price Index (CPI) is running at 0.2%, so it’s well below that target.

CPI, by the way, is a measurement of how prices change for an example ‘basket’ of goods and services from year to year. So, you might wonder why the government wants prices to rise all the time?

Economists argue it’s a good thing because it encourages us to buy stuff now, rather than delay until prices rise. This, of course, is good for business. The opposite effect would be deflation where prices fall year on year. If that happens, people tend not to spend on discretionary goods and services as they wait until prices drop.

Another argument for controlled inflation is that it gives a sense of hope, at least for those of working age who look forward to a pay rise each year. Imagine if you had to look forward to an annual pay cut, due to deflation?

But like all economic indicators, there are pros and cons. If inflation is too high, the Bank will increase interest rates to encourage people to save more and spend less. Debt becomes more expensive, so individuals are discouraged from borrowing to spend and businesses are discouraged from borrowing to invest.

On the other hand, if inflation is too low, the Bank will decrease interest rates to encourage more borrowing and spending. Good news for borrowers, bad news for savers.

There’s now talk of negative interest rates becoming a possibility. Imagine that. Mortgage rates dropping even further and saving rates moving into minus territory – having to actually pay the bank money for the privilege of looking after your savings. That’s a long way from the 15% interest rates I remember in the early 1990s.

Summary

So like our paddle board, the right amount of inflation is a good thing. It’s good for us individually and for the economy, but it’s important to understand why. Knowing that our finances are well set up to deal with changing interest rates and inflation can help with our wellbeing, just as much as some exercise and fresh air out on the water.

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