Interactive Investor

ii Top 10...things you need to know about inflation and your money

9th September 2021 11:00

Alex Sebastian from interactive investor

In this edition of the ii Top Ten series, our expert picks out the key things investors need to understand regarding one of the biggest issues for your finances, inflation.

1. The real value of money versus nominal

The real value of money is what it can actually buy you, not just what the number in a bank account is, known as the nominal value. In other words, real value refers to inflation-adjusted figures that incorporate price rises across the economy. For example, a loaf of bread in 1950 would cost a fraction of the price it does now. A pound back then would buy many loaves, whereas now you’ll only get one or two if you’re lucky.    

2. The money supply

Developed, modern economies are largely managed by central banks controlling the supply of money into the system. This changes according to the needs of the economy. Central banks manage the money supply using reserve requirements for banks and interest rates. Reserves are the amounts banks must hold on their books rather than lend out. The base interest rate is the cost of accessing money from the central bank. In recent times, the money supply has been surging due to quantitative easing.

3. Quantitative easing

Sometimes dubbed ‘money printing’, this has a huge bearing on inflationary pressure and the real value of your money. In times of crisis such as a pandemic, central banks can create a large amount of new money and use it to buy assets such as bonds. This money then filters through the financial system and pushes up the price of goods and services. Most money is created electronically as a computerised record, not actually printed or minted. Only 3% of the UK money supply is notes and coins.

4. Compounding

Compounding refers to the profit you make on investment gains that are reinvested and it is one of the most powerful forces that exists in terms of creating wealth. The effect increases over time as your investment pot gets bigger, like a snowball rolling down a hill. When your cash savings are not growing in value very much, due to a period of low interest rates like we are seeing now, you not only lose the immediate inflation-busting gains you would have made if you’d invested in a rising asset such as equities. Over time, you also lose out on all the compounded gains as well.

5. The target rate

Central banks around the world usually have a target rate for inflation. The Bank of England, for example, targets 2%, which is typical for developed countries. If inflation is bad news, then why do they have a target like that? Well, a small, tightly controlled amount of inflation is actually good news as it drives economic activity and gets the money supply circulating.

6. Average stock market returns

This is a crucial thing to research. Investing in a wide basket of stocks, such as one of the major indices, consistently beats inflation over time, thereby preserving and growing your wealth in a way that savings cannot, at least in recent times. This is because most of the rates available on savings are less than 1%, whereas a major index such as the S&P 500 returned an average of 13.6% over the past 10 years.

7. Pension implications

Due to the gradual reduction in real purchasing power of money, and the lack of compounding benefits, holding too much cash can be especially harmful for pension pots because they are invested over long time periods. Holding significant amounts of cash, or cash-like products, in a pension should only occur in the final few years of your working life, to cut risk as the time to retire nears.

8. The ways inflation is measured

You need to watch out for the various methods of measuring inflation. People quoting inflation, such as politicians, often choose the measure that suits them best. In the UK, we have Consumer Price Inflation (CPI) as the traditional main measure. This uses a basket of goods regularly bought by large numbers of people. More recently, the Consumer Prices Index with Housing (CPIH) has been used as the primary measure. This is similar to the CPI measure but with the average ‘owner occupier’s housing costs’ (OOH) factored in as well as consumer goods. OOH is based on the rise in equivalent rental costs. The Retail Price Index (RPI) measure is usually higher than CPI as it uses the ‘Carli formula.’ It is now discredited as that doesn't account for changes in shopping behaviour if prices rise. It is often quoted for political reasons or profiteering, such as in the case of train companies. Other weaknesses in RPI include a misleading use of housing cost data.

9. Wage spirals

These are another major inflationary force. Workers are always pushing for more pay and, when large numbers of them are successful, perhaps due to a tighter labour supply as we currently see with lorry drivers, there is more spending power across the economy and prices are pushed up. The more prices rise, the more people demand higher wages from their employers, and so on.

10. Stagflation

This is a nightmare scenario that central banks and governments strive to avoid. Stagflation occurs where inflation is high, but there is little to no economic growth driving it, low consumer confidence, low productivity and rising unemployment. It can come about due to policy mistakes made by central banks or governments. A good example is Britain in the 1970s where stagflation was caused by mismanagement of the economy combined with a big rise in oil prices.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.