What is inflation
So what is inflation?
....I hear you ask, and why do I need to know about it?
In simple terms, inflation is the rate at which the price of goods and services increases each year.
The reason we need to know about it as a financially literate investor, is because it can be a good thing, or a bad thing, depending on how you look at it, and what sort of investments and assets you have.
By way of a quick example, if your favourite coffee cost £2.00 today, and inflation was running at 10%, that same cup of coffee would cost you £2.20 this time next year.
However, if you left £2.00 in your savings jar at home for a year, then took it out to buy a coffee, it wouldn’t be enough now because of inflation. Your £2.00 would still be worth £2.00, but it is no longer enough to buy you the same coffee, which now costs £2.20.
Inflation can be seen as bad for cash, and cash-based savings, because the buying power of money is reduced by inflation every year. The higher the level of inflation, the quicker the money in your pocket loses its buying ability, meaning your standard of living falls.
Inflation can also be good for some types of assets, for example, homeowners like modest inflation, because it increases the value of their home, which makes them feel wealthier. People with investments in stocks and shares, also benefit from inflation, as generally the price of these assets, also increases in line with, or above the inflation rate.
The RPI inflation figure varies month by month over any period of years. Although the ideal and target level of inflation is about 2% in the UK, it varies both above and below this figure, and is very rarely 2% exactly.
The standard measures for inflation in the UK are the Consumer Price Index (CPI) and the Retail Price Index (RPI). The RPI is generally slightly higher than the CPI because it contains a different mix of products, which includes housing costs.
The Office for National Statistics (ONS) releases these inflation figures on a set date every month, and they are also reported in the newspapers.
What is inflation & real return
The key takeaway from this page is to understand that inflation erodes the value of cash in your pocket, or even in the bank if it doesn’t earn enough interest to beat inflation.
If Tom has £1,000 to put away in a savings account, and inflation is running at 2%, he needs to find a savings account that pays at least 2%, just to maintain his spending power. If his research concludes that the best interest rate he can achieve is only 1%, then his real rate of return for the year would be -1%. He would, in fact, be losing his spending power.
On the other hand, if he managed to find a savings rate of 4%, then his real rate of return would be +2%, and he would not only be maintaining his buying power, he would also be increasing it, which is the ideal position to be in, although not easy these days.
In order to grow your money, and achieve financial freedom over the long term, you generally need to invest your money, as opposed to, just saving your money.
We will discuss both of these options in detail later.