How inflation erodes the value of your money – Forbes Advisor UK
Inflation has been in the headlines in recent months, hitting a 40-year high of 10.1% in July before falling slightly to 9.9% in August. But then, in the 12 months to September, it rebounded again to 10.1%, more than five times the Bank of England’s official 2% target.
Rising food and energy prices have contributed to the current cost of living squeeze, as well as the Bank of England raising interest rates in an attempt to control inflation.
Here’s an overview of how inflation erodes the value of your money, as well as the current outlook for inflation and interest rates.
What is Inflation?
Inflation is the term used to describe the increase in prices over time. The inflation rate measures how quickly the prices of goods and services increase.
The rate of inflation is a way of measuring the decline in the purchasing power of money over time, in the following terms:
- Face value: the “face” value of money
- Actual value: the “relative” value of money in terms of the goods and services you are able to buy with the money.
Let’s take an example. You have £100 and over the next year the inflation rate is 10%. At the end of the year, the face or face value of your money remains at £100 (you still have £100 in your pocket).
But thanks to inflation, after 12 months you would 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 do we measure inflation?
The Office for National Statistics (ONS) measures the price of a “basket” of goods and services each month. The overall price of this “basket” is compared to the price a year ago, and the inflation rate is calculated as the percentage change in the price.
There are three main measures of inflation:
- Consumer Price Index (CPI): the overall measure of inflation which includes more than 700 everyday items such as food and drink, clothing and transport, auto repair and utilities, as well as larger items such as a car and vacation.
- Consumer price index with housing cost (HICP): a variation of the CPI that includes an estimate of housing costs, such as mortgage interest payments and council tax.
- Retail Price Index (RPI): previously used as an overall measure of inflation, it is no longer classified as an official national statistic since 2013 due to shortcomings in its calculation basis. The RPI includes housing costs and therefore tends to be higher than the CPI.
Why is the type of inflation measurement important? Well, the CPI is the measure of inflation used as the basis for the Bank of England’s interest rate decisions. This is 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 plan increases, index-linked gilt payments and rail fares. The government intends to phase out the use of RPI by 2030, which could lead to lower price increases for these items.
How has inflation changed over time?
Overall, inflation has remained fairly stable in the UK over the past 30 years, as shown in the chart below:
The government sets an inflation target of 2% and the Bank of England is responsible for achieving this target using monetary policies that include interest rates. The inflation rate exceeded this target from 2007 to 2013, partly due to rising commodity prices and an increase in the cost of imports due to the devaluation of the pound.
However, inflation has soared over the past 12 months, from 2% to its current rate of 10.1% (CPI, as of September 2022). This is the result of a combination of factors, including rising electricity, gas and petrol prices, supply constraints due to lockdowns in China and an increase in food prices, in part due to the war in Ukraine.
How has inflation increased the cost of everyday items?
Although average inflation has been slightly above 2% since 1990, this still has a cumulative effect on the price of items over time. And some products and services have seen price increases above inflation.
Here are the average prices of selected products over the past 30 years:
The cost of milk and bread has increased more than tenfold since 1970, while bananas are one of the few items whose price has fallen since 1995. The biggest increase is in the cost of gasoline, which has tripled since 1995 .
What items have increased in cost the most over the past year?
The inflation rate shows average price increases, however, some products and services have experienced higher than average inflation.
Let’s take a look at some of the supermarket products with the highest inflation rate over the past year:
Consumers have also faced “shrinkflation” where products have been reduced in size without a corresponding reduction in price. For example, some potato chip manufacturers have reduced the number of packets in their potato chip multi-packs.
This practice has been criticized because customers may not realize that they are indeed 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% because high inflation can cause large-scale problems for a country’s economy.
Hyperinflation refers to an uncontrollable rate of inflation, often defined as more than 50% per month and often occurs when there is a significant increase in the money supply that is not supported by economic growth.
Hyperinflation results in a rapid devaluation of the local currency against foreign currencies, while individuals begin to buy durable goods, such as household appliances, to avoid paying higher prices in the future.
This creates a vicious circle of rising prices, which can ultimately cause economic collapse, like 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 make saving more attractive. These two factors make people spend less.
In theory, prices are a function of supply and demand – if the demand for products and services drops, prices should rise more slowly, remain stable or even fall.
UK interest rates have been at historic lows below 1% for the past decade, as shown in the chart below. However, the Bank of England has raised interest rates seven times since December, with the current base rate standing at 2.25%.
The Bank of England is expected to continue raising interest rates this year to reduce inflation.
How does inflation erode the value of your money?
We calculated the impact of inflation on the real value of money as follows:
Inflation in the UK has averaged just over 2% a year since 1990, meaning it would have taken over 30 years for the real value of your money to halve.
However, based on the current inflation rate of 10.1% (as of September 2022), the equivalent time taken would only be on the order of seven years.
Although stock markets can also be affected by high inflation, they have historically provided superior returns to cash-based investments.
AJ Bell’s research 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 equity fund would have produced an equivalent pot worth £196,000 in real terms.