11 Jun 2023

Why you need to understand what inflation means for savings and debts

Paddleboarding has exploded in popularity over recent years and like the economy, the right amount of inflation is crucial for optimal performance. The consequences of incorrect inflation on a paddleboard can easily be imagined, but it’s less obvious when it comes to your money. It’s important to understand what inflation means for your savings and debts. Getting the balance right is not easy and with paddleboarding, I’ve found myself in cold water a few times.

It’s been a similar story for the Monetary Policy Committee at the Bank of England in recent years. The latest Consumer Price Index measure of inflation is 8.7%, as at April 2023, which remains way above the Bank’s target of 2%. You can check the latest rates of inflation here.

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 you 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 4.5%. This is a great improvement from the long period of sub-1% interest rates, but it may give a false sense of optimism. 4.5% is still below the inflation rate of 8.7%, so even the best savings accounts still lose money in real terms.

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, 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. That assumes 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 in the meantime.

 

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%.

CPI 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 you 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.

 

Summary

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.