Inflation has hardly been out of the news over the past few months. Last year we heard talk of deflation and we are now starting to hear the term stagflation, but what do they all mean, and more importantly how do they affect you?

Let’s start with some basics, what are inflation, stagflation, and deflation?

Inflation is the way we measure the rising price of goods and services. In the UK we have two measures, the Consumer Price Index (CPI) and the Retail Price Index (RPI). Both are measured by comparing the relative prices rises, or indeed falls, of a basket of goods believed to be relevant to our general spending habits.

RPI includes the cost of borrowing, CPI does not.

The UK has generally lived through times of positive inflation, however, last year deflation was thought by some to be a possibility.

As you would imagine the term deflation refers to time when prices are falling; this should be good you think? Well, not really, as during times of deflation people put off purchasing decisions to a later time when they believe the goods or services they require will be even cheaper, and as a result the economy stalls. The best example of how deflation can hurt an economy is Japan over the past decade or so.

Stagflation is a relatively new term and refers to a period when inflation is rising but the economy is stagnant with low growth and rising unemployment.

Where are we now?

We are certainly living through a time of rising inflation, most experts, including the Bank of England, expect inflation to rise as 2011 continues.

However, as we move into  2012, opinion becomes more divided. Some, including the Bank of England, believe that the causes of the recent rise in inflation are temporary and will fall away, leading to a reduction in inflation levels from 2012 onwards. Others believe that the opposite is true and that we are in for a period of sustained high inflation.

With inflation rising and growth slowing, stagflation is being seen by many experts as more likely over the course of 2011.

One thing is for certain, it would take a brave individual to forecast a period of deflation right now.

So, economics lesson over, how does inflation affect you?

High inflation affects everyone in different ways.

Firstly, wage inflation, that is the rate at which wages are rising, has fallen behind both CPI and RPI. This means that your income will not buy the same amount of goods or services as was previously the case.

For those on fixed incomes, for example if you have bought a level Annuity, inflation will erode the income at an even greater rate.

For those with savings, if you do not get a rate of interest that is above inflation, the value of your savings will be eroded. We have already shown in previous articles how hard it is to get an interest rate sufficient to beat inflation. For Cash ISAs and non tax payers you will have to tie your money up for at least three years to get an interest rate above inflation. Taxpayers, once they have used their ISA allowance, cannot currently get an account with an interest rate sufficient to beat inflation.

Finally, for those with mortgages, inflation could also be bad news. The Bank of England are coming under increasing pressure to push up interest rates to help keep inflation in check, if this happens the cost of borrowing will increase which in turn will push up monthly mortgage payments for those people not on fixed rates.

What can I do to help mitigate the effects of inflation?

There are a number of practical steps you can take to help mitigate the effects of inflation:

  1. Get your savings working as hard as you can for you, make sure you use your Cash ISA allowance and search for the best rates available on other accounts. Remember though if you fix your savings interest rate for too long you could be left with an uncompetitive account if interest rates do rise in months and years to come
  2. If you have previously invested in savings accounts, consider whether you should take more risk with your capital in the hope of getting a better return which will keep pace with inflation. This is not a step that should be taken lightly, you should do your research and take advice, however, it is one way of helping your savings keep pace with inflation
  3. If you have a mortgage, consider whether now is the right time to fix your interest rate. This would give you peace of mind that your monthly payments will remain the same if interest rates start to rise. However, it could involve paying more each month now, as many fixed rates are currently above lenders’ standard variable rates
  4. If you have reached the point where you want to convert your pension pot into an income, consider ways of inflation proofing your future income, for example by buying an escalating Annuity
  5. If you have a mortgage, consider whether you can repay a lump sum off the balance or make over payments each month to reduce the amount you owe. This will have a positive impact if interest rates do rise in months to come
  6. Shop around for the goods and services you consume, especially those that make up a large part of your monthly expenditure. The economy is still in relatively poor shape and companies want your business, use this to strike the best deal you possibly can

Conclusion

Most experts believe relatively high levels of inflation are here to stay, at least during 2011. Do everything you can to reduce its affects on both your income and savings.

If you would like to talk to one of our advisers about any of the issues raised in this article please contact us on 0115 933 8433 or 0845 074 7778, alternatively you can email us at info@investmentsense.co.uk