What is... | May 7, 2014

What is inflation?

Older people might remember when bread cost a third of the price it does today. Part of that rise in price will be because of inflation. And while some might not like the idea of paying more, many consider slow, sustained inflation to be a sign of a healthy economy.


But it makes saving for the future more complicated, particularly for people trying to work out how much money they will need in retirement.

How does inflation work?
Put simply, inflation is a general rise in prices.
It does not mean that all prices are rising – or that they are rising at the same rate. It means that the average in an agreed, weighted basket is going up.
If the inflation rate is 2% a year this means that if your shopping costs you EUR100 today, it would only have cost you EUR98 a year ago. If inflation stays at 2%, the same basket of shopping will cost you EUR102 in a year’s time.
This is why inflation is commonly referred to as eating away at the spending power of money.

Central banks focus on inflation
Avoiding excessive inflation is a major responsibility for many central banks as a way of enabling slow, stable growth for the economy. The European Central Bank, for example, targets inflation of below but close to 2%.
In the United Kingdom, if inflation (as measured by the consumer price index, or CPI) is more than one percentage point above or below the two percent target, the Bank of England’s Monetary Policy Committee must write a letter of explanation to the Government’s Chancellor of the Exchequer.

The good side of rising prices
It might sound strange but in some circumstances, high inflation can actually make money go further.
For borrowers with a fixed rate of interest for a long period of time (perhaps on a mortgage), inflation moving above the rate of interest effectively eats away at the debt. Especially if the borrowers’ wages keep up with inflation.
Or borrowers who time the market right, might lock into low interest rates by borrowing at fixed rates – possibly being shielded from subsequent inflation rises.

And the bad
On the other hand, some of the groups who tend to be losers from high inflation are earners and savers. If inflation jumps to 7% when your pay is only rising at 5%, your spending power is declining in what is called “real terms”.

Planning for the future
Over the long term, these small percentage differences can have serious implications for your money in retirement. When planning for retirement, it is key to factor in the impact of years of inflation.
Think of that earlier basket of shopping. What would happen to the price in 20 years’ time if the rate of inflation is still at 2% (a rate considered appropriate for many governments) but your wages do not increase? The cost of the goods in the representative basket will be 49% higher in 20 years’ time and 81% higher in 30 years’ time. Given that most people work for 30 years or more, the effect of inflation on standards of living can be dramatic.

What if…
Even when inflation is low, you cannot afford to ignore it.
Economist and eZonomics contributor Chris Dillow says that to combat rising inflation savers need to increase savings, even if it is difficult. If our money won’t grow by itself, we should add to it ourselves.
The eZonomics article five tips for beating inflation has more ways to get started, including trying to ensure earnings are at a higher rate than inflation and considering index-linked investments. Index-linked investments aim to ensure that the purchasing power of the investment does not deteriorate as prices rise. Such arrangements might be particularly attractive in high inflation environments, but beware their appeal may fall if the inflation rate slows or turns negative.

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eZonomics team
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