How Inflation Erodes The Value Of Your Money – Forbes Advisor UK

The inflation rate has made headline news in the last few months, reaching its highest level – 9% – in 40 years.

Rising food and energy prices have contributed to the current squeeze on the cost of living, together with the Bank of England increasing interest rates to try to control inflation.

Here’s a look at how inflation erodes the value of your money, along with the current outlook for inflation and interest rates.

What is inflation?

Inflation is the term used to describe the increase in prices over time. Tea missed of inflation measures how quickly prices of goods and services are rising.

The inflation rate is a way of measuring the decline in the purchasing power of money over time, based on the following terms:

  • Nominal value: the ‘face’ value of money
  • Real value: the ‘relative’ value of money in terms of the goods and services that you are able to buy with the money.

Let’s take a look at an example. You have £100 and, over the next year, the inflation rate is 10%. At the end of the year, the nominal or face value of your money remains at £100 (you still have £100 in your pocket).

But thanks to inflation, after 12 months you’d need to spend £110 to buy what £100 would have bought you a year earlier.

Another way of looking at it is that your original £100 is ‘worth’ 10% less than it was a year ago.

How is inflation measured?

The Office for National Statistics (ONS) measures the price of a ‘basket’ of goods and services every month. The overall price of this ‘basket’ is compared to the price one year ago, and the rate of inflation is calculated as the percentage change in price.

There are three main measures of inflation:

  • Consumer Price Index (CPI): the headline measure of inflation which includes over 700 everyday items such as food and drink, clothes and transport, car repair and utility services, along with larger items such as a car and holiday.
  • Consumer Prices Index with housing costs (CPIH): a variation of CPI which includes an estimate for housing costs, such as interest payments on mortgages and council tax.
  • Retail Price Index (RPI): previously used as the headline measure of inflation, this has not been classified as an official National Statistic since 2013 due to shortcomings in its basis of calculation. RPI includes housing costs, and as a result, tends to be higher than CPI.

Why does the type of inflation measure matter? Well, the CPI is the measure of inflation used as the basis for the Bank of England’s interest rate decisions. It’s also part of the ‘triple lock’ calculation which determines the annual state pension increase.

However, the RPI is still used as the basis for some pension scheme increases, index-linked gilt payments and rail fares. The government intends to phase out the use of RPI by 2030, which could result in lower price increases in these items.

How has inflation changed over time?

On the whole, inflation has remained fairly stable in the UK over the last 30 years, as shown in the graph below:

Source: ONS data, CPI data remodeled for comparison purposes

The government sets an inflation target of 2% and the Bank of England is tasked with achieving this target using monetary policies including interest rates. The inflation rate exceeded this target from 2007 to 2013, due in part to rising commodity prices and an increase in the cost of imports due to the devaluation of the pound.

However, inflation has soared in the last 12 months, rising from 2% to its current 30 year-high of 9.0% (CPI, as at April 2022). This is the result of a combination of factors, including rising prices for electricity, gas and petrol, supply constraints from lockdowns in China and an increase in food prices, partly due to war in Ukraine.

How has inflation increased the cost of everyday items?

Although average inflation has been just over 2% since 1990, this still has a cumulative effect on the price of items over time. And some products and services have experienced above-inflation price rises.

These are the average prices of selected products over the last 30 years:

The cost of milk and bread has increased more than ten-fold since 1970, while bananas are one of the few items to fall in price since 1995. The biggest increase is in the cost of petrol, which has tripled since 1995.

Which items have increased the most in cost in the last year?

The inflation rate shows average price increases, however, some products and services have experienced above-average inflation.

Let’s take a look at some of the supermarket products with the highest rate of inflation over the last year:

Consumers have also faced “shrinkflation” where products have reduced in size without a corresponding reduction in price. For example, some crisp manufacturers have reduced the number of packets in their multi-packs of crisps.

There has been criticism of this practice as customers may not realize that they are effectively paying higher prices relative to the size of the product.

Why is inflation a problem?

The UK government sets a target inflation rate of 2%, as high inflation can cause wide-scale problems for a country’s economy.

Hyperinflation refers to an uncontrollable rate of inflation, often defined as over 50% per month and often occurs when there is a significant increase in the supply of money that is not backed by economic growth.

Hyperinflation results in a rapid devaluation in the local currency against foreign currencies, while individuals start to buy durable goods, such as consumer appliances, to avoid paying higher prices in the future.

This creates a vicious cycle of rising prices, which may ultimately cause economic collapse, as in Zimbabwe.

How is inflation controlled in the UK?

The Bank of England uses interest rates as a tool to control inflation. Higher interest rates make it more expensive for people to borrow money and makes saving money more attractive. Both of these factors result in people spending less.

In theory, prices are a function of supply and demand – if demand for products and services falls, this should result in prices rising less quickly, remaining the same or even falling.

Interest rates in the UK have been at historically low levels of below 1% for the last decade, as shown in the graph below. However, the Bank of England has increased interest rates on five occasions since December, with the current base rate standing at 1.25%.

Source data: Bank of England

The Bank of England is expected to continue to raise interest rates this year to reduce inflation. Independent research provider Capital Economics forecasts that the base rate will peak at 3.0% in mid-to-late 2023, before falling slightly to 2.5% in 2024.

How does inflation erode the value of your money?

We’ve calculated the impact of inflation on the real value of money, as follows:

Inflation in the UK has averaged just over 2% per year since 1990, meaning that it would have taken over 30 years for the real value of your money to halve.

However, based on the current inflation rate of 9.0% (as at April 2022), the equivalent time taken would be only eight years. What’s more, if inflation reaches 10% as forecast, this period of time would fall even further to just seven years.

While reducing expenditure on everyday items may help households to reduce the impact of high inflation, this is not the case for money held in savings accounts.

According to the latest Bank of England figures, the average interest rate on new savings accounts is 0.9%. With the current inflation rate of 9.0%, money in savings accounts is losing 7.4% in real terms each year.

Although stock markets may also be impacted by high inflation, they have historically delivered superior returns to cash-based investments.

Research by AJ Bell shows that a saver using their entire ISA allowance from 2011 to 2020 would have a cash ISA worth £125,000 in real terms. However, investing in the average global stock market fund would have produced an equivalent pot worth £196,000 in real terms.

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