The price you pay: How inflation takes a toll on your budget
By Kate Leaman, Chief Market Analyst at AvaTrade
Inflation is the rise in the price of goods and services over time and impacts everyday life and can significantly impact your finances, ultimately costing you money. While a moderate level of inflation is considered healthy for an economy, it can erode your purchasing power and affect various aspects of your financial life.
For March, the inflation rate in Britain came in at 10.1 per cent, ensuring that inflation remained above the 10 per cent mark for a seventh consecutive month. This is more than five times than the Bank of England’s inflation target of 2 per cent, as well as being more than double the rate of inflation seen in the US.
One way inflation affects your wallet is by reducing the value of your money. As prices rise, the purchasing power of each unit of currency diminishes. For example, if you have $100 today, and the inflation rate is 3 per cent. In a year’s time, those same goods and services that you could purchase for $100 would cost you $103. This means that your money can buy you less than it could before, effectively reducing your wealth.
Currently, food prices are rising at their quickest rate in the UK since 1977, reaching a 17.1 per cent inflation rate by the end of April, driven largely by food shortages and higher energy bills within the country. With the cost-of-living crisis still prevalent, it is no doubt that people are struggling.
As the cost of production and raw materials increases, businesses often pass these expenses onto consumers, resulting in higher prices. This means you may have to spend more of your income on basic necessities, leaving less room for discretionary spending or saving. As inflation increases, individuals are more conscious of their spending habits. For instance, they may make the decision to reduce personal expenses on nonessential items like leisure and entertainment. To curb consequences, the Bank of England has tried to control inflation by raising interest rates to 4.25 per cent as a way of encouraging people to spend less and borrow more. This will particularly impact those with a mortgage or a credit card loan, who will have to pay more interest than previously anticipated.
What’s more, unemployment rates in Britain increased to 3.9 per cent in the three months leading up to March. As inflation rates increase faster than income, it is imperative that the ways in which inflation can cost money are known to individuals. Inflation impacts aspects of everyday life, but there are ways in which individuals can protect themselves from it.
Investments and savings are worth less
Inflation can impact your savings and investments. If the rate of inflation exceeds the interest rate you earn on your savings account or investments, the real value of your money can decline. For instance, if the inflation rate is 5 per cent, but your savings account only earns 2 per cent interest, your purchasing power is effectively decreasing by 3 per cent each year. Investments such as shares and property are affected by inflation as it can cause their value to decrease. This is due to the fact that income from these investments is fixed, but the costs of managing them with maintenance and insurance rises accordingly with inflation.This can make it challenging to build wealth and reach your financial goals.
Risk is increasing
Investing in shares and property can be rewarding. However, whilst you make these investments when inflation is maintaining a high rate, it ultimately comes with risks attached. This is because the costs of these assets are connected to inflation – so as the rate of inflation increases, the value of your investment may subsequently decline.
Lack of preparation
Preparation is vital when it comes to inflation. As it has an evident effect on finances, it is imperative for people to be aware of its influence. Otherwise it could lead to consequences, such as if you have not prepared to diversify your portfolio, some of your assets may lose their value. Additionally, having investments in the pipeline may increase your savings in the long term, ata time when the interest rates on savings are lower than the inflation rate. Having a plan in place therefore makes a difference in protecting yourself from the effects of inflation.
Inflation can cost you money in various ways, but just because it can doesn’t always mean it should. There are ways in which people can mitigate the potential damage caused by inflation.
Inflation is a continuously changing rate. A prominent way in which you can protect yourself from the consequences of it is staying informed and keeping up to date with the latest news, as well as following economic data, which can make it easier to recognise the first signs of inflation.By staying informed about inflation trends and making proactive financial decisions, you can minimise the negative impact of inflation on your money.
Needless to say, planning ahead is a crucial way to protect individuals from inflation. For instance, those individuals who engage with trading should have a trading plan for inflation-proof stocks. This can also mean investing in a diversified portfolio such as stocks, bonds, cash equivalents, and real assets like property. This is because if during inflation one of your investments loses its value, your other investments may still retain theirs.
Whether it be investing time in acquiring new skills and knowledge, focusing on yourself can help you manage the impacts of inflation. Educating yourself is important as it allows you to understand what is happening in an ever-changing economy and can help you when it comes to identifying risks which can help shield individuals from financial burdens.
Whilst investments and diversifying your investments reaps awards, it is important to keep in mind that the risk is higher in a time of inflation. Therefore, being able to stay disciplined and stay on track on your investment plan and not letting emotion play into purchases is vital.
Seek professional support
As inflation rises and uncertainty increases accordingly with it, seeking professional support can help individuals understand the ways they may be impacted, as well as receive expert advice on the best ways to manage inflation.
The impacts of inflation are ubiquitous and unavoidable – but that doesn’t mean they can’t be managed. By understanding the ways inflation can cost you money, individuals can identify when they are at risk. Ultimately, having the appropriate knowledge and skills on the ways to ease the effects of inflation can help individuals save money.