Inflation is the measure of the rate at which the average price of goods and services goes up in an economy over a period of time. It results in the reduction of buying power of a nation’s currency, thus increasing the cost of living and decelerating the economic growth of a country. Inflation is caused by factors including an increase in the demand for goods and services more than the country’s production capacity, higher money supply by the government through easing its monetary policies and rise in production costs. It is measured with reference to the Consumer Price Index (CPI) and is calculated by dividing the final CPI index value by the initial CPI value.
The inflation rate has shown an interesting trend during the coronavirus pandemic. While the pandemic reduced both the demand and supply of goods and services, the government increased the money in circulation through quantitative easing. As a result, the inflation rate has remained much below the inflation target of 2%, at around 0.2% in March 2020. However, over time, as the demand and supply are slowly picking up and the monetary policies continue to remain loose, a spell of inflation can be foreseen, with the inflation rate rising to 0.60% in June 2020 against the forecast of 0.40%. The inflation rate is expected to be at 1.19% for 2020, which hurts savings and investments.
Inflation Affects Your Savings
Inflation has a negative impact on savings and shrinks them with time. For instance, if you have £100 in your savings account that pays an interest rate of 1%, you will have £101 at the end of the year. However, if the inflation rate is more than the interest rate, at say 2%, you will require £102 to have the same buying power as at the beginning of the year. Thus, you will effectively lose money if your savings do not grow at the same rate as inflation.
The situation has become even more critical in the current times with record-low interest rates. At the current rate of interest paid to the savers, the money saved and interest earned will not be enough to offset the loss in value of money caused by inflation.
How Inflation Impacts Investments
The impact of inflation on investments varies with the type of investment. It harms fixed-return investments like bonds and certificates of deposit. These investments generate a fixed return each year, and rising inflation reduces the value of that money with every passing year. On the other hand, the impact of inflation on stock investments majorly depends on the company’s performance, its revenues, and costs of goods and services.
Additionally, investments in precious metals like gold and silver perform well at the time of inflation as the price of these metals increases with rising inflation. Some bonds and annuities are inherently indexed for inflation. They generate high returns when the inflation rate is high and low returns when the inflation rate is low, thereby keeping the overall returns stable.
Plan for Inflation
Investors and savers to plan for inflation and be prepared as inflation erodes the future value of money. The most significant way is diversification. While fixed-return assets like bonds are less risky, their returns get negatively affected by inflation and may add to the overall inflation risk of the portfolio.
Therefore, you must diversify your portfolio into high-growth investments, including stocks and mutual funds, that usually generate a higher return than the inflation rate. It helps in keeping the value of savings and investments intact and unaffected by inflation.
Inflation-Proof Investments and Savings Options
It is advisable to invest in inflation-proof securities taking the adverse effect of inflation on investments into account. The savers and investors are recommended to prefer inflation-linked government bond funds rather than the conventional gilts or Treasuries. A few examples of such bond funds include Royal London Index-Linked and MI Twenty-four Dynamic Bond. Such funds offer diversification and flexibility, in addition to lower vulnerability to inflation and other economic changes.
Furthermore, precious metals also work as efficient inflation-proof investments. Metals like gold directly benefit from inflation. Investors can also diversify their portfolios by including inflation-resistant equity income funds with reliable performance records.