Inflation: What Is It and Why Does It Matter?
In a nutshell:
Inflation is decreasing the value of your money each year. Hence, instead of saving your money in a current account earning minimal interest, start investing to beat inflation!
- Inflation is where the price of goods is increasing
- Deflation is where the price of goods is decreasing
- Current UK inflation is around the target level of 2%
- Inflation erodes the value of your money, so invest to offset and beat this!
- Economic Context
- Why is it important?
- Invest to beat inflation
- Inflation adjusted-returns
Inflation is a macroeconomic variable that economists measure.
Essentially, all it means is that goods and services increase in price each year, assuming it is >0.
Whereas, negative inflation is called deflation, and as you guessed it – this is where goods and services decrease in price each year.
The Bank of England has a target each year of 2% +/- 1%. So, really, inflation is targeted around 1-3%, with 2% being the sweet spot. After the 2008 Financial Crisis, inflation was low for years and years, which was why the Bank of England decreased interest rates to 0.5% and kept them there year after year, to try to encourage us to spend. These low interest rates helped increase inflation back to their target level. Today it is currently 1.9%.
Generally speaking, if consumer confidence is high then we spend more, increasing prices. This is why typically inflation will increase during the economic cycle, until there is a recession, then it will start to decrease as spending is reigned in.
Alternatively, if the government increase the money supply, this will also increase inflation as there is more money buying the same amount of goods. This is what the Bank of England have been doing under a program called Quantitative Easing (QE).
We have a post on our Instagram detailing what the causes of this in a slightly more technical way, using economic theory!
There are two main ways to measure inflation in the UK, the CPI and the RPI – both measures look at the average price change of a basket of goods. However, the difference is that RPI includes mortgages/rent, whereas the CPI doesn’t.
Why is it important?
If prices are increasing each year, but your money has been sitting in the bank earning little to no interest, then you are worse off each year!
Inflation is 3% and you have £100 in the bank. Lets assume a loaf of bread costs £1.
In year 1 you can buy 100 loaves of bread.
However, by year 5, a loaf of bread will now cost £1.16, because of inflation.
Therefore, that £100 that has been sitting in the bank earning pretty much no interest can now only buy 86 loaves of bread!
Inflation erodes our money
Currently, one of the best UK easy-access savings accounts is Marcus by Goldman Sachs, earning us 1.5% for the first year. But, inflation is currently sitting at around 1.9%. Hence, although being a ‘high-interest’ account, we are still losing 0.4% of our money.
Whilst this is certainly better than leaving your money in a high street bank earning little to no interest, it would be more beneficial to expose yourself to the stock market and start investing!
Investing to beat inflation is just one of the many reasons why you should invest (reasons why you should invest!).
Invest to beat Inflation
Historically, we can expect a 7-10% return on our money from the stock market, over the long-term.
Let’s look at the same example:
Inflation is 3% again, but now we invest the £100 instead of keeping it in the bank, and earn 7% in the stock market each year.
By year 5 we will have £140.
Investing has grown our money
Before, after 5 years we could only buy 86 loaves of bread at £1.16 each. Now, we can buy 120 loaves of bread at £1.16 each, because our money has been growing in the stock market!
Whilst we appreciate this is a simple example, it helps demonstrate that investing is a great way to not only offset, but also beat, inflation.
However, before investing, it is important consider specific factors, such as your risk tolerance, time horizon and goals.
As a side note – whenever someone quotes the return they made in any given year, check if the return they made is inflation-adjusted.
Meaning whatever return they give you, make sure they have taken away the inflation percentage from their return percentage.
For example, if someone says they made 10% in a year but inflation was 7% then they really only made 3% in real terms that year!
This is the basic idea of inflation, and why we should be investing to do our best to beat inflation.
But, it is important to invest for the long-term, as whilst stock market returns from year-to-year can swing wildly, the market goes up over time – so follow an investment strategy and watch your money beat inflation over your lifetime!