What is inflation?

The inflation rate is increasing in the UK for the first time since coronavirus. But what is inflation and how does it affect me?

The UK inflation rate

The UK’s inflation rate increased 0.6% from June 2019 to June 2020. 

This inflation rate falls below the UK central bank’s year-over-year target of 2%. But considering the impacts of Coronavirus, this increase is generally considered a positive signal. 

What is inflation?

Inflation is the change in the prices we pay for goods and services. Older generations often say they remember when movie tickets, candy bars and fuel were much cheaper. Those prices have risen largely due to inflation.

Inflation is measured by how much prices have increased over a period of time. It usually discussed in 12 months (one year) periods.

Prices can also go down – this is called deflation. It’s also worth noting that each currency has a different inflation rate. For example, the US dollar will inflate at a different rate than the pound or euro. 

Why inflation matters

Inflation matters a lot because if prices inflate too much, we can buy less with our money. 

For example, if inflation is 2% over the past year, we can expect to spend 2% more for the same items at the grocery store, cafes, petrol stations and so on.

Ideally, salaries would increase at pace with inflation, but this is not always the case.

In the above example, if your salary did not increase 2% over that same year, you will not be able to buy as much as you could 12 months ago. Therefore you have less purchasing power and your standard of living has dropped.

If your salary increases 2%, you have the same purchasing power. If given a 3% raise, you now have slightly more purchasing power. 

Is inflation good or bad?

A bit of inflation is generally a good thing. Central banks in most countries target 2% to 2.5% inflation each year. The main upsides are:

  • Companies tend to increase wages to match inflation
  • Knowing that prices rise over time encourages people to make bigger purchases sooner rather than later
  • Small levels of inflation can be good for stimulating economic growth

How will this affect me?

At the end of the day, there are two things you should be aware of for your personal financial planning:

Inflation benefits for borrowers: interest rates will probably stay low 

Inflation is used to help calculate interest rates. Because the UK’s central bank expected inflation to be below the target 2%, it has already lowered interest rates to 0.1%. This is to encourage borrowing and boost the economy. 

Because inflation increased by only +0.6% in July, it is likely rates will remain low. This means it’s a relatively cheap time to take out a loan, and may be for a while longer. 

Inflation disadvantages for savings: savings accounts grow more slowly
Low interest rates are good if you are borrowing, but not if you’re saving. Cash in a checking or savings account earns interest. But the interest rate is impacted 

by the central bank’s interest rate. And when inflation is low 🡪 interest rates are low 🡪 banks pay you lower interest on your savings. 

If you are a cash saver, understand that your money is probably earning less interest than in prior years. So check your bank’s rates and consider where else you can put cash to get a better deal. 

To see how your money is doing, use Money Dashboard, a free app that consolidates data from all of your accounts, giving you a simple, accurate view of your finances. 

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