When it comes to prices, things seem to be heading in one direction – up. Whether it’s the price of petrol at the pumps, the monthly household costs or the bill when you eat out, it certainly feels as if we are getting less for our money.
It might have come as a surprise therefore that inflation hit the headlines for a more ‘positive’ reason recently. In January, UK inflation was reported to have fallen to a two-year low, coming in at 1.8% and therefore falling below Bank of England’s target level of 2% for the first time in 2 years. This level was also maintained in February 2019.
But just what is inflation and how is the national inflation rate derived?
To put it simply, inflation is the increased cost of buying things, such as your weekly supermarket shop. The way in which inflation is calculated is not so simple.
The ONS sets out three main measures of consumer price inflation – CPI (the Consumer Prices Index), CPIH (the Consumer Prices Index that also includes the costs of owning a home) and the Retail Price Index.
According to the ONS, the consumer price indices are calculated by collecting a sample of prices for a selection of representative goods and services in a range of UK retail locations including the internet. The ‘basket of goods’ on which calculations are based are reviewed each year to ensure they remain ‘representative’. Currently, there are a total of 714 items in the ‘shopping basket’ across 12 main categories – including food and non-alcoholic beverages, clothing and footwear, communication, recreation and culture and restaurants and hotels.
The ONS states that every month, it gathers around 180,000 separate price quotations that are used to compile their indices, covering around 700 representative consumer goods and services. These prices are collected in around 140 locations across the UK, from the internet and over the phone.
But why does the level of inflation even matter?
Inflation has the power to impact the power of the pound at every level – from our everyday spending on essentials to the level of return we receive on certain investments.
The level of inflation and whether it goes up or down has the potential to impact different people in different ways. In the main, keeping inflation at a relatively low level is beneficial as this means that the everyday items we need to buy should remain at an affordable level.
The headline rate of inflation is one thing, but on a personal level, you may find that you are being hit even harder by price increases. You only need to look at the price of your weekly food shop to see prices creeping up at an alarming rate. Furthermore, household energy bills have recently risen by over 10%, and the average increase in council tax bills will go up by as much as 4.5% across the UK this year. Clearly, all of these price hikes are much higher than the government’s reported inflation rate and have the potential to impact an individual’s personal monthly disposable income.
If you sit down and work it out, you might therefore find that the Real Inflation Rate – the rate that applies to you and your own personal spending – is far higher than the reported national inflation rate, perhaps at 4%, 5% or potentially even more.
With this in mind, what can individual investors do to protect themselves against the impact of both the nationally reported Inflation Rate, and their own Real Inflation Rate?
One of the key things to point out is the relationship between the rate of return of a savings or investment product and inflation. Despite the rise in the base rate in August 2018 to 0.75%, the UK remains in a low interest rate environment. Low interest rates at the country-wide level translate into low interest rates for individuals – and as such, the rates offered by high street banks on savings accounts remain pitifully low. The danger of this is that those that favour holding their money in mainstream banking accounts may, over time, find that the value of their money being effectively eroded as inflation at a higher rate pushes prices up. So in reality, even with falling inflation, it will still be very hard to get returns above inflation from such cash deposit accounts this year. This is particularly an issue for women – who are statistically more likely to hold money in cash accounts rather than invest.
Where people are willing to take a risk with their money, investing, rather than merely saving, is the way to grow your money faster than inflation.
What’s inflation and how does it affect your purchasing power?
Inflation decreases the value of the pound — meaning you can buy less with that pound over time.
Inflation isn’t a particularly complicated concept. All the stuff you spend money on — be it milk, rent, hairspray or movie tickets — can be bundled up together to come up with what’s called “cost of living.” As the cost of living rises — a number reflected in what’s called the consumer price index, or CPI — that pound that use to buy two candy bars now barely buys one. That’s inflation.