What does soaring inflation mean for your finances?

What does soaring inflation mean for your finances?

 · 5 min read

While moderate inflation is healthy for an economy, soaring inflation can wreak havoc with your finances. Moderate inflation allows for moderate wage increases and price rises, maintaining relative spending power. However, unless the value of your investments, savings, and income can keep pace with inflation, your relative spending power comes under pressure.

  • UK inflation is soaring, pushing up food and energy prices.
  • Soaring inflation can also affect house prices, pensions, and other investments.
  • You may find yourself less wealthy in real terms due to soaring inflation unless your investments and other assets are generating a return ahead of the inflation rate.

Inflation and your finances: FAQs

  • How is inflation measured?

    Several measurements are used by the UK government and the Bank of England, with the Consumer Price Index (CPI) the most popular. This is calculated using the ongoing cost of a “basket” of goods and services, representing the average household and changing consumer trends.

  • What are the benefits of inflation?

    Inflation in moderation is an integral part of long-term economic growth, fuelling price and wage growth. In addition, some annuities and bonds are linked to inflation, which means that the associated income increases in line with inflation. Controlled inflation is essential to economic growth; soaring inflation is unsustainable and impacts relative spending power.

  • Who controls inflation in the UK?

    While inflation is not controlled as such, it is the role of the Bank of England to introduce monetary policies which will influence inflation. So, for example, during periods of soaring inflation, you tend to see interest rate increases. As a consequence of increasing the cost of debt, consumer spending falls, demand follows, and pricing pressure is relieved.

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Over the last few months, inflation has been in the news, eventually forcing the Bank of England to increase base rates. The annual inflation rate hit a 30 year high of 5.4% in December 2021, as measured by the Consumer Price Index (CPI). Even though much of the recent rise in inflation is a consequence of rising energy costs, product supply issues have also contributed. Greater demand for goods and services will create upward pricing pressure in a simple supply/demand scenario.

Inflation is defined as "a decrease in the purchasing power of money, reflecting a general increase in the price of goods and services in an economy", but what does it mean for us? 

What does soaring inflation mean for your grocery shopping?

To measure inflation, the CPI includes a basket of goods and services taking in an array of sectors such as:

  • Food and beverages
  • Alcohol and tobacco
  • Clothing and footwear
  • Furniture and household goods
  • Health
  • Transport
  • Communication
  • Recreation and culture
  • Education
  • Restaurants and hotels
  • Miscellaneous goods and services

So, in effect, the CPI is a measurement of the rising cost of grocery shopping, although not all prices will move in the same direction at the same rate. One of the significant side effects of inflation is the cost of running a business, such as wages and suppliers. As salaries and supplier prices rise, retailers need to increase prices to maintain profitability, potentially creating a vicious circle.

What does soaring inflation mean for house prices?

The Bank of England's target rate for inflation at the moment is 2%, well below the current rate of 5.4%. Regarding house prices, moderate inflation is healthy as this allows an increase in rents, which supports higher house prices. However, there is a challenging underside to high inflation regarding house prices.

If the cost of living continues to grow and house prices continue to rise, this may price many would-be buyers out of the market. The mortgage affordability test considers income and living expenses to calculate affordable mortgage payments. While the long-term trend in house prices is upward, due to limited supply and growing demand, the more people priced out of the market, the less upward pressure on prices.

What does soaring inflation mean for your savings?

In relative terms, soaring inflation is not beneficial for savers. For example, at this moment in time, savings interest rates are negligible, and inflation is currently running at 5.4%. Even if we were to take instant access savings rates at 1% (very generous), this does not compare favourably to the rate of inflation. In the real world, while your £100 savings will increase to £101 in 12 months, the cost of living will increase from £100 to £105.40. So, in relative spending terms, your savings are down 4.4%, and this is only over one year. 

Long-term high inflation and low interest rates can decimate savings in relative terms. For example, if we were to see a savings rate of 1% and inflation of 5.4% for five years, your savings would be worth £105.10 while the relative cost of living would have increased to £130.07. 

What does soaring inflation mean for your investments?

Controlled inflation, with the Bank of England believing a 2% rate is manageable, is favourable for investments, allowing companies to increase their prices. However, the situation is very different with soaring inflation.

Stock markets and investments

As we touched on above, where inflation is soaring, it is unlikely that businesses could pass on total wage increases and supplier price rises while maintaining sales. This places business management in a difficult situation. If they increase the cost of services and goods at the inflation rate, they may be unaffordable to many, and sales would likely fall. On the flip side, a partial increase in prices could may current sales but at reduced margins. Either way, the short to medium-term growth prospects would be impacted, creating potential downward pressure on share prices.

Interest rates

As we have seen recently, interest rates are often used to combat inflation. Increasing interest rates increases the cost of consumer debt, such as credit cards and bank loans. The knock-on effect is that consumers have less money to spend on goods and services, taking the heat out of soaring price rises. However, reduced upward pressure on prices and reduced consumer spending is not ideal for companies to grow their profits.

When it comes to investments like property, an increase in the cost of debt will price many people out of the market. Likewise, reduced demand will have a knock-on effect on achievable prices.

What does soaring inflation mean for your pension?

There are several issues to look at concerning soaring inflation and pension income. As the state pension and defined benefit pension schemes incorporate annual increases linked to inflation, there is no impact. However, it is essential to note that the so-called triple lock on the state pension is under review.

The situation is slightly different regarding money purchase pension schemes and annuities not linked to inflation. With inflation currently at 5.4%, if you have a money purchase pension scheme, you would need to increase your assets by 5.4% a year to stand still in relative terms. Those with flat rate annuity income will see their income eroded in relative terms by inflation.

Soaring inflation can ruin your finances

As we touched on above, both directly and indirectly, soaring inflation can considerably impact the cost of living, investments, and income. Manageable inflation is healthy for an economy, allowing moderate price increases to maintain relative profitability for companies and keep pace with wage inflation. However, unless your income can keep pace with inflation, this creates a scenario where your relative spending power is in constant decline.

Mark Benson
Mark Benson
Mark joined Age Group in 2020 and has over 10 years’ experience specialising in writing around property, finance, and investment subjects.
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