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Inflation – What is it and how can it affect your savings?

There has been a lot of talk in the news lately regarding inflation, both in the UK and globally, with many predicting some sharp increases on the horizon. 

Indeed, in his recent Autumn budget, the Chancellor announced that the rate of inflation in the UK is expected to average 4% in 2022. To put that into some perspective, the rate of inflation in July this year was 2%. With lots of headlines, jargon and political ping-ponging, it can be difficult to keep track of exactly what is happening. So, we have provided some explanation on how inflation can affect your savings over the long term.

What is inflation?

Inflation in the UK is measured by the Consumer Prices Index (CPI). In short, the CPI represents the cost of a typical basket of goods and services purchased by most households in the UK.

Changes in the CPI are announced every month, meaning that we can keep track on how prices in the UK are constantly changing.

How can inflation affect you?

To demonstrate the effects of inflation, let’s consider an example. 

If you were to go to your local supermarket today with £100, this would allow you to purchase a certain basket of goods. 

However, if over the next 12 months the rate of inflation is 3%, it would then cost you £103 to purchase those same items next year.

In short, due to the rate of inflation, your £100 has lost some of its spending power – or some of its ‘real’ value.

Does inflation affect your cash savings?

Over the long-term inflation can mean that your cash savings lose some of their ‘real’ value. This happens when the rate of inflation in the UK is higher than the rate of interest you are earning from your cash savings.

For example, if inflation is at 3% but your cash savings are paying an interest rate of 0.5%, then your savings will not be keeping pace with inflation.

To demonstrate this, the chart to the right shows the rate of return which an individual would have received from the average UK bank savings account over the last 5 years up to 30/09/21 (as measured by the UK Savings £2,500+ Index), in comparison to the rate of UK inflation over the same period.

The graph shows that over the last 5 years, the average UK cash account has returned just +0.89% to savers, whereas the cost of goods & services in the UK has risen by +11.15% over the same period.

This means that those who have held all of their savings in cash over the last 5 years will have seen the ‘real’ value of their capital eroded, and their money will be able to buy fewer goods & services today than it would have 5 years ago.

Don’t get us wrong, there are some advantages to holding some capital in cash; the main one being that cash is seen as a ‘safe-haven’ by many. That is, there is no underlying investment risk when holding cash in a bank/building society savings account 
and – providing the bank/building society does not fail – the capital value of your funds should never go down. 

Additionally, holding some funds in cash allows for easy access to capital in the event of an emergency or unforeseen spending need which may arise.

However, we can clearly see above the potential negative impact of holding excess cash over the long-term.

How can you combat the effects of inflation?

For those who have sufficient assets and capacity to take on investment risk, one of the best ways to tackle inflation is to invest into assets such as Equities (shares), Bonds and, up until recently, property. 

Over the long-term, these assets have tended to produce returns over and above both cash savings and inflation. 

Via our multi-asset approach to investing, we would typically expect that a diversified investment portfolio with a suitable risk approach should be able to ensure that the ‘real’ value of your capital grows over the medium and longer terms – or is at least maintained. 

The contents of this article are for information purposes only and do not constitute financial advice. Past performance is not a guarantee of future returns, and you may get back less than you originally invest.