With the current cost of living crisis and the talk of inflation in the news almost daily we want to share the basics of what inflation is and why it matters when you are saving and some advice on what you can do about it.
What is inflation?
Most people broadly understand what inflation is: it is when something costs you more than it used to, but when saving money for the future, it is really important to understand that inflation can have a negative impact on your savings.
Inflation can be caused by a wide variety of factors: for example a restriction in supply of oil after the Russian invasion of Ukraine meant an increase in the price of petrol or lots of people wanting to travel after the pandemic resulted in airfares increasing as the number of flights was limited. Inflation affects different products and services in different ways but when inflation occurs, the same amount of money can buy fewer goods and services compared to before.
Why does inflation matter?
The reason it is critical to understand is that if the value of your savings increases at a lower rate than the level of inflation, then the purchasing power of your savings decreases and you will be able to buy less with them in future than you can now.
To give an example. In May 2023, inflation was nearly 10%1. This meant that on average what had cost you £100 in May 2022 would now cost £110 twelve months later. Interest rates on savings accounts were lower than this: if you put had put £100 into a saving account in May 2022 paying, say, 4%, then a year later you would have had £104 which could now buy less than a year before.
When thinking about long-term financial goals such as saving for retirement or education, it is really important to be aware of inflation. Over several years or decades, inflation can significantly impact the amount of money you will need to meet those goals and it is crucial to consider inflation when setting savings targets and investment strategies.
What can you do about it?
Wait for interest rates to rise to more than inflation.
Since 2007, interest rates in the UK have been lower than inflation2 but for some other time periods, interest rates were higher. To help control inflation, the Bank of England has been setting higher interest rates. While this may benefit your savings, the costs of borrowing on mortgages or credit cards may increase.
Although it is wise to keep some money in savings in case you need it in a hurry, when inflation is taken into account, it may take a long time for rising interest rates to get above inflation.
Invest rather than save
Unlike saving where your returns are dependent on the interest rate, returns from investing depend on how well the investments do.
There is of course a risk that you could end up with less than you put in but evidence suggests that, over the long term, stocks and shares tend to outperform cash as the returns can compensate for the ups and downs. For example, the Barclays Equity Gilt Study in 2019 showed that over 50 years, UK shares would have returned 4.7% whereas cash would have returned 1.1%. In some years cash would have significantly outperformed equities but over the longer term it was the other way around.
You need to be prepared for the value of your investment to go up and down, but the longer you stay invested, the more potential your money has to grow – and recover from any setbacks along the way. So when planning for the longer term over multiple years, it is worthwhile considering investing rather that putting the money into a savings account.
1.Source: Office for National Statistics CPIH all goods index.
2. Source: World Bank real interest rates 1967 to 2014