A controlled level of inflation is an important part of a healthy economy because it encourages steady growth and prevents deflation. It’s why the Bank of England (BoE) maintains an inflation target of 2%.
While deflation – the price of goods and services dropping – may seem positive, it is often a sign that consumers are holding on to their cash instead of spending it. If left unchecked, this can cause the economy to stagnate, which is why a little inflation is generally considered necessary.
In recent months, however, you’ll have read headlines that the UK inflation rate is significantly above the BoE target. Inflation was 7.9% in the 12 months to June 2023, according to the Office for National Statistics (ONS).
Unfortunately, at this level, inflation can negatively affect your wealth in several ways. The good news is, there are ways to potentially counteract the effects of inflation so you can meet short-term financial obligations and continue working towards your long-term goals.
Read on to learn how inflation could affect you, and what you may be able to do about it.
Your living expenses could increase
The rising cost of key expenses like energy, fuel, and food is a big driver of high inflation.
For instance, according to figures from the ONS, inflation for food and non-alcoholic beverages was 18.4% in the 12 months to May 2023.
As a result, you could well notice that your living expenses increase, potentially making it more difficult to contribute to pensions, savings, or investments.
Indeed, a survey conducted by the Pensions and Lifetime Savings Association found that 47% of respondents said they were unable to save money during the cost of living crisis.
Unfortunately, failing to save and invest, or reducing contributions to your pension now could make it more difficult to meet your long-term financial goals.
Inflation can reduce the real-terms value of your cash savings
While you may notice the effects of inflation on your regular income first, it is also important to be aware of how it could affect your cash savings.
When the rate of inflation is higher than the interest rate on your savings account, your money could lose value in real terms.
Say, for example, you put £1,000 in a savings account with 4.35% interest – the best easy access savings account interest rate according to Moneyfacts – you would have £1,043.50 a year later.
Yet, if inflation is 7.9% the same goods that cost £1,000 now will cost £1,079 in a year. So, as you can see, inflation can harm the purchasing power of your cash savings.
If inflation remains high for an extended period, this could disrupt your long-term savings goals.
Rising interest rates may make borrowing more expensive
The government set the BoE a target of bringing inflation down to 2% and keeping it there.
Increasing interest rates is one way they are attempting to reach this target. High interest rates make borrowing more expensive, meaning that consumers spend less. This should reduce the demand for goods and slow price rises.
On 22 June 2023, the BoE increased the base rate again to 5% – the 13th consecutive rise – and many lenders increased their interest rates to follow. This could mean that borrowing is more expensive for you.
For example, according to Rightmove, on 11 July 2023 the average interest rate on a two-year fixed-rate mortgage with a loan-to-value (LTV) ratio of 95% was 6.75%.
That is a significant increase from the average effective fixed rate in November 2022 which, according to the ONS was just 2.08%.
If your current mortgage deal is coming to an end, this could mean that your monthly outgoings suddenly increase. Additionally, repayments on credit cards or loans could go up too.
This combination of increased outgoings and higher borrowing costs can make it more difficult to meet short-term obligations. To add to this, the reduced real-terms value of your cash savings may disrupt your medium- to long-term goals.
Fortunately, there are ways you may be able to protect your wealth from the effects of inflation.
5 ways to protect your wealth from high levels of inflation
1. Make the most of tax-efficient savings
Finding tax-efficient ways to save allows you to retain more of your wealth and, in some cases, gives you an extra boost.
When you save in an ISA, for example, you do not pay any Capital Gains Tax (CGT) or Income Tax on the interest or investment returns. So, it may be a good idea to use as much of your £20,000 ISA allowance in 2023/2024.
Pension contributions are also a tax-efficient way to build savings as you benefit from tax relief at your marginal rate. As a result, you may be able to reduce your Income Tax bill by increasing pension contributions. Additionally, the investment returns and employer contributions you receive could help your savings grow faster than the rate of inflation.
2. Shop around for better interest rates
Shopping around for a better interest rate could lessen the effects of inflation, to some extent.
Rates are always changing so it may be a good idea to check regularly and see if you can get a more favourable interest rate on your cash savings. However, bear in mind that current savings account interest rates are not likely to beat inflation.
It may also be a good idea to consider the interest you pay on borrowing. Remortgaging to benefit from a lower interest rate, for example, could significantly reduce your living costs.
3. Consider making more investments instead of holding large amounts of cash
While it’s important to have an emergency fund, investing some of your wealth may be beneficial as, historically, investments offer higher returns than savings accounts.
The average annual return of a Stocks and Shares ISA over the last 10 years is 9.64% according to The Motley Fool, for example.
While investment returns vary and past performance doesn’t guarantee future returns, your investments may be more likely than cash savings to keep pace with inflation.
This means you may be able to retain the value of your wealth in real terms during a period of high inflation.
4. Clear outstanding debts
Clearing expensive debt may reduce your monthly expenses, freeing up more of your regular income to contribute to your pension or investments.
If you have a significant amount of cash savings in an account with a low interest rate, it may be a good idea to use some of it to pay off a portion of your debts.
5. Revisit your financial goals
When inflation makes it more difficult to meet short-term financial obligations and save for the future, it may be useful to revisit your financial goals.
Working with a financial planner can help you to make the necessary changes to your plan so you are still able to achieve the lifestyle you want now and later on.
Get in touch
It’s easy to worry about the effects of inflation but with the right adjustments to your financial plan, you can protect your wealth and remain on track to meet your goals.
Please get in touch to find out how our team of VouchedFor top-rated planners could help today.
Please note
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.
A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.
The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.