What is inflation and should we worry about it?

The Consumer Prices Index rose by 3.2% between August 2020 and August 2021, marking the highest level of inflation we have seen in the UK for almost nine years. But what exactly does this mean for your finances? Our Chartered Financial Planner Görkem Gökyiğit explains.

What is inflation?

Inflation is a measure of how much the price of goods and services have increased by over time. Typically, we measure inflation by comparing it to the cost of things today, versus how much they cost 12 months ago. For example, if a litre of milk costs £1.50 today but it cost £1.43 last year, it means the price of milk has risen by 5%.

The UK’s inflation rate is currently around 3.2%, meaning the general price of goods and services this year is around 3.2% higher than last year.

Of course, not everything rises in linear fashion; some goods will have risen by more than 3.2% since last year, and other things will have fallen in price.

Why is it important to measure inflation?

Inflation is an important statistic because as prices rise, the amount of goods and services one can buy falls. This then leads to a slowdown in economic growth, which can impact other important areas, such as employment levels and living standards.

How do governments control inflation?

In order to keep inflation in check, most countries have a central bank that controls money supply. Central banks use two main monetary policy tools that control inflation:

1. Setting interest rates

Changes in bank rates feed through to how much interest households get on savings and how much interest people pay on a loan. This affects the amount of spending in the economy, and so helps inflation to either fall or rise.

2. Buying bonds

Central banks buy government bonds or corporate bonds from other financial companies and pension funds. When they do this, the price of these bonds tend to increase, which means that the bond yield (or interest rate) that the bond holders receive tends to decrease.

Often a lower interest rate on UK government and corporate bonds then results in lower interest rates on loans for households and businesses. This helps to boost spending in the economy and keep inflation at target levels.

Should we worry about high inflation in the UK?

The inflation rate in the UK has been fairly low for over a decade. Although it’s currently higher than the Bank of England’s 2% target, it’s still seen as relatively low in comparison to other countries around the world.

Some experts believe that the inflation we are experiencing is just a correction from last year, as prices were abnormally low due to consumers limiting their spending during the COVID-19 pandemic. They therefore believe the 2021 increase shouldn’t raise concerns, as going forward inflation rates will be transitionary.

Others argue that the amount of money that has been pumped into the economy by the government means that higher inflation is here to stay. If the inflation rate continues to be above the 2% target, then the Bank of England is likely to start raising interest rates, which will impact everyone with mortgages and personal loans.

What steps should you take now?

Regardless of whether inflation is transitionary or not, if you have surplus cash in your bank account generating almost zero returns, it’s recommended that you consider utilising that capital so that it keeps its purchasing power in years to come.

How can we help?

If you’re looking for further guidance or would like to find out more details on how the changes to inflation may impact you, please get in touch with our Chartered Financial Planner Görkem Gökyiğit (gorkemgokyigit@lfwm.co.uk).

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