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What can you do to reduce the impact of inflation on your personal finances?

05.04.22

By Nicholas Powell

What is inflation?

Inflation refers to a general increase in the price of goods and services and the consequent decrease in buying power of a given unit of currency. Higher prices mean you get less for your pound. The Office for National Statistics (ONS) measures inflation by comparing the prices of a selection of goods and services to their prices 12 months earlier. The percentage increase is the ‘inflation rate’. You can find up to date figures on the current rate of inflation on the ONS website.

Why is the inflation rate rising at the moment?

Some recent events, the Covid-19 pandemic, Brexit and the Russian invasion of Ukraine, have led to shortages and supply chain disruption across the globe. Increased demand and lack of supply when restrictions eased in 2021 caused prices to rise which, coupled with the global energy crisis, have triggered a steep rise in inflation.

What effect does inflation have on different areas of personal finance?

The effect inflation will have on your personal finances will depend on your individual circumstances but there are some areas where almost everyone will feel the effects.

Purchasing power

Purchasing power is an indicator of how much of an item you can purchase with a single unit of currency. Ultimately, inflation reduces your purchasing power. For example, an inflation rate of 6.2% would mean that an item previously purchased for £100, would now cost you £106.20. Alternatively, you could find that your money will buy you a smaller quantity of an item. This is commonly known as ‘shrinkflation’; where businesses look to reduce the quantity of a product to mitigate their cost increases, rather than increase the price to the consumer for the original quantity. Not taking into account changing wages, over time a rise in inflation will mean your money will either become less valuable, or of less use.

Savings

The Central Bank sets the base interest rate, and this is the rate that other banks can usually borrow at. An increased interest rate is designed to discourage borrowing and to encourage saving, both of which effectively reduce spending and demand. A reduction in overall spending helps to curb the rate of inflation. An increase in the base rate doesn’t always equate to an increase in the saving rates offered by high street banks. This is one of a number of reasons why a savings account is not a viable long-term savings solution.

The main reason is the interest rate obtained from banks and building societies is likely to remain below the rate of inflation. With the inflation rate several percentage points above the base interest rate, money in a bank account will drop in real-terms value over the years as the amount of interest paid is unlikely to keep pace with inflation. It is important to keep an emergency short term cash reserve, and a savings account will usually be appropriate for this. However, for money for longer term use, a savings account is less likely to be the best option.

What measures can you take to limit the effect of inflation?

Investments and diversification

If you’re saving for the long term, such as retirement or university fees for children, it might be advisable to take the investment route. Although not guaranteed, stock markets can be a more appropriate investment during periods of increased inflation as companies increase their prices to maintain their margins, which stabilises the value of their shares. Higher than expected base interest rates can force stock market values lower, but over a full cycle of economic growth and recession, investment commentators would expect shares to usually offer protection against inflation.

Diversification is the key to long-term investment; for example, a portfolio that includes investment in property, equities, fixed interest stocks (bonds), and commodities, will help you to ride out market volatility and has the potential to lead to long-term gains. Taking into account your goals, the amount you have to invest, and your appetite for risk, a financial adviser will help you to invest your money in a way that’s right for you.

Utilise the experience of an independent financial adviser (IFA)

Planning ahead for the long-term will help you to understand your current position and what your goals are. With the help of an IFA, you can then put together a strategy to get there. An IFA can look at your pensions, savings, investments, cash flow, retirement, and inheritance planning. An all-encompassing objective look at your personal finances can help you to plan for the short-term budgetary pressures brought on by inflation, but also help to keep you on track for the long term.

For example, an IFA can use cashflow modelling to calculate how much money you will need for the lifestyle you want in retirement. It is possible to amend the underlying assumptions used in the forecasting tool so that you can see the effect of higher than expected inflation on your future cost of living. Running different scenarios through a cash flow forecasting tool will help you to test if your saving and investment provision is sufficient to meet your future financial requirements. The experience of an IFA will help you to navigate these choices.

Consider asset-backed investments

An asset-backed investment, such as property or high-value collectors’ items, can prove to be a viable hedge against inflation in the longer term. There are a number of reasons why purchasing property can be successful at combating the effects of inflation:

  • Rising property prices over a number of years can lower the loan-to-value of a mortgage, therefore averaging out the effect of inflation and higher interest rates that come with a tracker mortgage.

  • Purchasing a property to rent out (either as a holiday let or assured-shorthold tenancy), can provide an income that keeps pace with inflation. Inflation often causes a rise in wages, which in turn causes a periodic rise in rental rates and the return you would get on your investment.

  • Traditionally, property prices have increased at a steady pace, often outstripping the pace of inflation.

However, it’s worth bearing in mind that many people’s main asset will already be their property, and therefore it’s important to make sure you’re not solely relying on property to provide a return on your investment. Diversification isn’t limited to investing in the stock market, it should be considered across your entire strategy.

The value of investments and any income from them can go down as well as up and you might not get back the original amount invested. The past is not a guide to the future. The value of tax benefits depends on your individual circumstances. Tax laws can change.

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