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In the wake of the Covid19 pandemic, inflation has been fairly flat over the last year. But economic activity is starting to pick up again, with strong rebounds predicted for the coming 12 months.
While this is good news, some concerns have been expressed about the impact on inflation.
So how does inflation work, and should you be worried?
How Inflation Works
Inflation is an economic term which refers to the increase in prices.
The usual measure of inflation is the Consumer Price Index (CPI). This is a theoretical basket of goods and services which are purchased by a typical household. It includes food, clothing, transport, and many other routine expenses that an average person might incur.
Other indices, such as the Retail Price Index (RPI), also measure inflation, but use a slightly different ‘shopping basket.’
It is the Bank of England’s responsibility to keep inflation at a stable, moderate level. The target inflation rate is 2%. Over the past 5 years, the rate of inflation has fluctuated between 0.4% and 2.7%.
There are multiple factors which cause inflation to fluctuate:
- It is generally expected that wages will, on average, increase every year. This has two main consequences:
- Workers have more money to spend, which leads to more demand for goods and services.
- Companies have to put their prices up to cover the increased wage bill.
- Lower interest rates can also increase disposable income, as the cost of borrowing reduces and savings rates become less attractive.
- When demand overtakes supply, prices rise.
- Rising prices in one area can have a knock-on effect across the economy. For example, increased oil prices result in higher costs across multiple other industries. Businesses need to raise their prices to continue making a profit.
- When prices rise, workers demand higher wages to keep up with increased costs. And so the cycle continues.
Low, stable inflation is generally a sign of a strong economy. This is regarded as positive because:
- Prices are rising, which means business is profitable.
- The economy is more predictable, leading to greater certainty over cashflow.
- Low inflation creates confidence, which encourages investment.
- Savings and investments tend to hold their value or out-perform inflation.
But the economy is cyclical, and inflation rises and falls just like anything else.
Care must be taken not to dip into negative inflation, where prices drop. This usually works as follows:
- Demand reduces for goods and services.
- As a result, companies’ profit margins fall.
- To stay in business, they may have to reduce prices.
- They might also have to reduce payroll costs, which can lead to increased unemployment.
- Lower levels of employment mean less disposable income in the economy.
- Reduced productivity means that the companies supplying the original business are also affected.
- Share prices drop, which impacts investments and pension funds.
- The downwards trend in prices continues until something happens to reverse it.
Central banks will aim to control (or avoid) negative inflation by reducing interest rates and increasing the supply of money.
High inflation occurs when prices rise more quickly than normal. This can also be problematic, and is not usually sustainable for a long period.
Some of the consequences of high inflation are:
- Essential goods and services become more expensive.
- Wages might not keep up with the cost of living.
- Companies face pressure to increase salaries, which leads to higher prices and reduced profits.
- Benefits and other public service costs increase, which means that taxes may also need to rise.
- Savings and investments can lose value in real terms.
High inflation is usually caused by an increased supply of money in the economy. Low interest rates can also be a contributing factor, as it becomes more attractive to borrow and spend than to save. Shortages can also lead to high inflation, as prices rise in line with demand.
If left unchecked, high inflation can tip into hyperinflation, which was seen in Germany after the First World War. Shortages of goods and the printing of more money caused prices to rise to uncontrollable levels. Workers were paid twice a day to try and keep up with rising prices, and by 1923, it cost more to print a banknote than the currency was actually worth. The resulting problems led to political instability, the rise of the Nazis, and eventually the Second World War.
Governments can take the following steps to reduce or maintain inflation:
- Increase interest rates, making it more expensive to borrow and more appealing to keep money in the bank.
- Control the money supply and keep the printing of money at sensible levels.
- Impose higher taxes to reduce disposable income.
- Introduce measures to increase supply and productivity, or to limit wage increases.
Inflation can also reduce naturally as other economic factors and fluctuating commodity prices start to take effect.
How Inflation Can Affect Your Financial Plan
Inflation is one of the factors that needs to be accounted for in your financial plan. We can make assumptions about the rate of inflation, but like investment values, it will fluctuate and rarely behaves exactly as predicted.
The following aspects of financial planning can be affected by inflation:
Your financial plan most likely assumes that your earnings will increase each year to keep up with the cost of living. Is this realistic? In some industries, an inflationary pay rise is expected every year. But this is not the case for everyone, as demonstrated by the recent caps on public sector pay increases.
If you are self-employed or run a business, your earnings depend on many other factors and are not directly linked to inflation.
So when creating your financial plan, it may not be appropriate to simply assume that your income will increase with inflation. Any assumptions used should be relevant to your situation.
Spending and Budgeting
If inflation is high, your spending could increase more quickly than you planned. A short period of higher prices is not usually a problem, as most people tighten their belts accordingly. But sustained inflation can mean that a typical household income does not have the same spending power.
In your financial plan, a typical assumption would be that your spending increases each year in line with the assumed inflation rate. In reality, you probably won’t increase your spending every year. In other years, you might spend more. A realistic financial plan aims to average out these variations.
High inflation means that your cash balances will probably lose value in real terms. This is particularly the case when interest rates are low.
But this doesn’t mean that you shouldn’t hold cash. It’s vital to keep an emergency fund and to account for any planned spending. This means that you can avoid going into debt or dipping into investments if you receive an unexpected bill.
Life insurance, critical illness cover and income protection are important components of any financial plan.
But the benefits selected when you set up the plan might not be worth as much in 10 or 20 years. This means that your cover may not be enough for its intended purpose.
Most new policies will allow you to add an indexation option, which means that your cover level rises with inflation. Your premiums would increase at the same rate.
It’s worth reviewing your protection plans to ensure that they are future-proof.
Inflation will not affect your existing debts. In fact, assuming prices, wages, and investment values are all rising, your debts will be worth less as a percentage of your net worth.
Taking on new debts using these assumptions is a risky move, as it could leave you financially vulnerable if things change.
Sensible financial planning means not taking on more debt than you can afford. It is also best to avoid consumer debt where possible, as the items you can buy on a credit card are unlikely to bring you closer to your goals.
A key aim of an investment plan is to ensure that your money holds its value or increases in real terms when inflation is taken into account. Investing in equities usually boosts long-term growth, but creates more volatility in the shorter term.
Asset classes fluctuate on a daily basis, and inflation is only one of the factors affecting this.
The best way to protect your portfolio from inflation risk (and other risks) is to hold as wide a variety of assets as possible, and avoid concentrating too much money in one area.
When planning for your retirement, you will need to consider:
- How much you are likely to spend
- The rate at which you will increase your spending
- Any future sources of income, such as State or occupational pensions
A retirement income of £30,000 per year might seem like more than enough, but it won’t have the same spending power in 20 or 30 years. And remember, retirement lasts for many years, and inflation remains a constant.
When you build in realistic inflation assumptions, you might find that you need to save more than you think to create your ideal retirement.
Please do not hesitate to contact a member of the team to find out more about how inflation could affect your financial plan.
Please don’t hesitate to contact a member of the team to find out more about financial planning. Book a free call with a member of our team today, without obligation. We look forward to speaking with you.