How Inflation Erodes The Value Of Your Money – Forbes Advisor UK

In October 2022, inflation reached its highest level in 41 years at 11.1%. The figure has since fallen back to 2.0% in the 12 months to May (from 2.3% the previous month). This is the Bank of England’s official target.

Here’s a closer look at how inflation erodes the value of your money, along with the current outlook for inflation and interest rates.

What is inflation?

Inflation is the term used to describe the increase in prices over time. The rate of inflation measures how quickly prices of goods and services are rising.

The inflation rate is a way of measuring the decline in the purchasing power of money over time, based on the following terms:

• Nominal value: the ‘face’ value of money
• Real value: the ‘relative’ value of money in terms of the goods and services that you are able to buy with the money.

Let’s take a look at an example. You have £100 and, over the next year, the inflation rate is 10%. At the end of the year, the nominal or face value of your money remains at £100 (you still have £100 in your pocket).

But thanks to inflation, after 12 months you’d need to spend £110 to buy what £100 would have bought you a year earlier.

Another way of looking at it is that your original £100 is ‘worth’ 10% less than it was a year ago.

How is inflation measured?

The Office for National Statistics (ONS) measures the price of a ‘basket’ of goods and services every month. The overall price of this ‘basket’ is compared to the price one year ago, and the rate of inflation is calculated as the percentage change in price. 

There are three main measures of inflation:

• Consumer Prices Index (CPI): the headline measure of inflation which includes over 700 everyday items such as food and drink, clothes and transport, car repair and utility services, along with larger items such as a car and holiday. 
• Consumer Prices Index with housing costs (CPIH): a variation of CPI which includes an estimate for housing costs, such as interest payments on mortgages and council tax.
• Retail Prices Index (RPI): previously used as the headline measure of inflation, this has not been classified as an official National Statistic since 2013 due to shortcomings in its basis of calculation. RPI includes housing costs, and as a result, tends to be higher than CPI.

Why does the type of inflation measure matter? Well, the CPI is the measure of inflation used as the basis for the Bank of England’s interest rate decisions. It’s also part of the ‘triple lock’ calculation which determines the annual state pension increase. 

However, the RPI is still used as the basis for some pension scheme increases, index-linked gilt payments and rail fares. The government intends to phase out the use of RPI by 2030, which could result in lower price increases in these items.

How has inflation changed over time?

On the whole, inflation has remained fairly stable in the UK over the last 30 years, as shown in the graph below:

The government sets an inflation target of 2% and the Bank of England is tasked with achieving this target using monetary policies including interest rates. The inflation rate exceeded this target from 2007 to 2013, due in part to rising commodity prices and an increase in the cost of imports due to the devaluation of the pound.

However, inflation soared in 2022, peaking at over 11% in October of that year. By November 2023 it had fallen to 3.9%. It has now dropped to its current level of 2.0% (May 2024).

High inflation was the result of a combination of factors, including rising prices for electricity and gas, supply constraints from lockdowns in China and an increase in food prices, partly due to war in Ukraine.

How has inflation increased the cost of everyday items?

Although average inflation has been just over 2% since 1990, this still has a cumulative effect on the price of items over time. And some products and services have experienced above-inflation price rises. 

These are the average prices of selected products over the last 30 years:

The cost of milk and bread has increased more than ten-fold since 1970, while bananas are one of the few items to fall in price since 1995. The biggest increase is in the cost of petrol, which has tripled since 1995.

Why is high inflation a problem?

The UK government sets a target inflation rate of 2%, as high inflation can cause wide-scale problems for a country’s economy.

Hyperinflation refers to an uncontrollable rate of inflation, often defined as over 50% per month and often occurs when there is a significant increase in the supply of money that is not backed by economic growth. 

Hyperinflation results in a rapid devaluation in the local currency against foreign currencies, while individuals start to buy durable goods, such as consumer appliances, to avoid paying higher prices in the future. 

This creates a vicious cycle of rising prices, which may ultimately cause economic collapse, as in Zimbabwe.

How is inflation controlled in the UK?

The Bank of England uses interest rates as a tool to control inflation. Higher interest rates make it more expensive for people to borrow money and makes saving money more attractive. Both of these factors result in people spending less. 

In theory, prices are a function of supply and demand – if demand for products and services falls, this should result in prices rising less quickly, remaining the same or even falling.

Interest rates in the UK have been at historically low levels of below 1% for the last decade, as shown in the graph below. However, the Bank of England has increased interest rates on 14 occasions since December 2021, with the current base rate standing at 5.25%.

How does inflation erode the value of your money?

We’ve calculated the impact of inflation on the real value of money, as follows:

Inflation in the UK has averaged just over 2% per year since 1990, meaning that it would have taken over 30 years for the real value of your money to halve. 

Although stock markets may also be impacted by high inflation, they have historically delivered superior returns to cash-based investments. 

Research by AJ Bell shows that a saver using their entire ISA allowance from 2011 to 2020 would have a cash ISA worth £125,000 in real terms. However, investing in the average global stock market fund would have produced an equivalent pot worth £196,000 in real terms.