Whilst on holiday, touring the Highlands of Scotland, I’ve been making good use of my inflatable paddle board. It’s not always easy to get balance right and I’ve found myself in cold water a few times. Unfortunately, I have a small leak, which means having to boost the paddle board with some additional inflation every so often.
It’s been a similar story for the Monetary Policy Committee at the Bank of England in recent years. They’ve had to keep interest rates at a record low level of 0.1% and they’ve used quantitative easing to prevent the economy from deflating.
Like my 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.
This month, the UK rate of inflation increased to 2.5%, so in real terms, virtually all savings accounts will now be losing value. Like my paddle board losing pressure, your cash loses its buying power if inflation is higher than the interest rate you earn.
Over the long term, that can be catastrophic. For that reason, 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, it’s a good antidote to the long term impact of inflation.
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 techniques. But the main thing is that the Bank of England is targeted to keep inflation at around 2%.
With the latest rise in the Consumers Price Index (CPI) to 2.5%, it’s now above that target. And so begins the debate and speculation on when, and how fast, interest rates might rise.
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.
So like my 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 the exercise and fresh air that I enjoy, out on the water.
If you’d like to learn more about how you can arrange your finances to deal with the effects of changing interest rates and inflation, get in touch for a chat!