Inflation is the way we measure how much the value of goods rise in an economy over a period of time. It indicates the value of a country’s currency.
The Bank of England says:
“Inflation is a measure of how much prices of goods (such as food or televisions) and services (such as haircuts or train tickets) have gone up over time.”
For example, if inflation were set at 5%, then a packet of biscuits you bought a year ago for £1 would now cost you £1.05 for the same packet. It means that your pound is now worth less than it was a year ago.
In the UK the inflation target is set by the Chancellor of the Exchequer and is usually set at 2%. It is important to maintain a delicate balance between inflation and a healthy economy.
Disinflation is when interest rates begin to fall. If interest rates were high to begin with then this in itself is not damaging. In fact, the closer a country can maintain its inflation to the 2% target, the better. However, if deflation occurs – which is a real ‘drop in prices’ – then there can be economic trouble. If prices are likely to fall in the future, then people will be tempted to put off spending until then. This means there is a sharp drop in consumption. They are also less likely to borrow money, as they do not need to purchase on credit because their currency buys them more. If loans aren’t taken out, then new money isn’t created, and the economy becomes depressed.
Conversely, if inflation rises too high – such as 8-9% - then the value of the currency is eroded too much and the cost of living becomes too high to support a healthy economy as people cannot afford to purchase anything other than necessities, and all their money is eaten up by cost of living expenses. This means that no savings or investments are made (especially if inflation rises at a faster rate than wages).
How does it affect my house price?
There is a definite correlation between inflation and house prices. Houses are ‘goods’ just like everything else, meaning that (just like the biscuits above) house prices will rise in-line with inflation. This can lead to many people being priced out of the market, as prices rise faster than wages.
In economies where inflation is low, or where there is deflation, then people are less likely to spend, as the longer they hold onto their cash the more it will buy them tomorrow. This will eventually hurt your house price as, as demand drops, so too will your house price.
How does it affect my savings?
Inflation affects the value of currency. What you could have bought for £1 in 1990 you now need £2.07 to buy today. In effect, its ‘purchasing power’ has declined. That’s why, over time, you need your money to grow at least at the same rate as inflation.
If you are putting your money in a savings account it needs to offer you at least the same amount of interest as the projected inflation rate of that year. If it doesn’t it means that your money is actually losing its value. Therefore, the higher the inflation rate, the more value your savings have lost.
It’s for this reason that it is always recommended to responsibly invest your savings in order to ensure they grow and, at the very least, retain their value.
How does it affect my investments?
There are a number of ways in which inflation can affect your investments.
Bonds, for example, suffer under high inflation rates, as their interest rates are fixed. People are therefore less likely to invest, as the interest rates may not keep up with the increased cost of living.
In the stock market, inflation means that each year you are paying more for a stock that has no more inherent value than it did the year before; it’s just that your currency buys you less. In an ideal world, however, a company’s value should grow at least at the rate of inflation, therefore insuring that your investment at the very least holds its value over time.