Only 38% of UK adults know what inflation is, according to research from The Organisation for Economic Cooperation and Development (OECD). The data also shows that adults in at least 14 nations have a better understanding of inflation than Brits.

To help put this situation right, we’ve created a short explainer covering the main points. However, we always encourage you to read further, learn more and seek professional help when you need it.

What is inflation?

Put simply, inflation is the rising cost of goods and services. Over time, the products that we buy will go up in price. Inflation is unavoidable, in fact, steady and manageable inflation is beneficial to the economy, but it is the rate at which it increases which affects us most. That’s why the Bank of England (BoE) has a target of keeping inflation at 2%. With inflation currently at 3.1%, it has taken action by increasing interest rates, to try to pull the rate of inflation back to target.

Inflation is measured and reported most widely through the Consumer Price Index (CPI), which shows changes in the average price of goods and services across the UK. Whilst it does not reflect individual markets, it shows the pace at which household expenditure rises.

The Office for National Statistics (ONS) recommends thinking of the CPI in terms of a shopping basket. The basket represents the typical goods and services which households may spend money on. It includes all expenses, from basic food to annual holidays and leisure activities.

As a whole, this basket will have a monetary value, calculated using the average prices for those products. However, the cost of the items will change over time and the basket value will rise accordingly.

The effects of inflation

As inflation rises:

• The cost of buying essentials rises
• Interest rates may increase
• The buying power of both your capital and income are decreased
• Making big purchases becomes more difficult
• Your savings are de-valued

When inflation rates are high, almost everyone is affected in some way. However, different groups see different outcomes, for example:

Savers: If inflation is consistently higher than interest rates, savings will decrease in real term value. This means that, even though savings accounts are designed to minimise risk, savers will see a loss of capital value anyway.

Annuity holders: Annuities are designed to pay a guaranteed income for life. There are two types; level and Index-linked. Level Annuities do not rise year on year, therefore, those people with this product could find themselves struggling to keep up with the cost of living as the years pass.

Employees: Without pay rises which match inflation, employees will see their buying power decrease over time.

Consumers:  As inflation pushes up the price of goods and services, your buying power reduces. To illustrate:

If you deposit £1,000 at a time when a new television costs £200, you could buy five.

A year later, the interest rate is 1%, but inflation is at 2%.

Your savings are now worth £1,010, but a television costs £240. You can only afford four televisions, even though your savings have increased in value, the purchasing power has been affected severely.

Similarly, household income is worth less over time. Although inflation has a constant effect, with the price of living steadily rising at all times, pay rises are not as frequent. ONS data shows that the average weekly earnings across the UK are rising over time. But in real terms, salaried and hourly-wage incomes are not changing.

The same is true for pensioners who have purchased an Annuity; as they provide a set income each month, which cannot be altered and is not protected against inflation.

For both workers and pensioners, their set monthly income loses value, due to the increased cost of living. That means that any expendable income which may have been put toward savings will gradually decrease.

Offsetting the effects

It is not easy to combat the effects of inflation and it is an ongoing battle. However, there are a few options available to help you to protect your income and savings from erosion:

Savings accounts:  Interest rates vary throughout the savings account market. There are products available which offer returns that are close to the rate of inflation. Although it is unlikely that you will find rates which are equal to, or above the CPI.

Budgeting effectively: Whilst the cost of living is increasing overall, it is always possible to shop more effectively. Looking for offers, trying different brands and comparing products by price-for-weight, rather than shelf price are all great ways to save money on essentials.

Save money where possible: If your income is squeezed, putting money aside might be your last priority. But even choosing to take a packed lunch to work, rather than buying a meal deal every day can give you an extra pound or two to put away for a special occasion.

Take financial advice: Independent Financial Advisers are experienced in helping people from all walks of life and backgrounds to make the most of their income. They can help you to find the right savings account, manage your budget more effectively and plan for your future.

To discuss how you can better position yourself financially, contact us.