Why has inflation increased?
Whilst the news continues to be dominated by the terrible events in Ukraine, the impact on the global financial system is unfolding before us. The cost of energy has soared, which has impacted both individuals and businesses. This has been compounded by a shortage of materials such as plastic and concrete and high demand for the services of shipping companies who transport the goods that we buy around the world.
This increased cost of producing goods & services for businesses have been passed on to consumers in the form of price rises with inflation in the U.K. reaching 5.5% in January 2022, its highest increase since February 1991.
Why are interest rates relevant?
To combat inflation, the Bank of England (and central banks all over the world) are gradually increasing interest rates in an attempt to ‘cool’ the demand for goods & services. This makes it more attractive to savers to ‘park’ their money in the bank whilst also increasing the cost of borrowing money.
For most people this higher cost of borrowing results in increases to their mortgage payments. The Bank of England hopes that the higher cost of borrowing will mean people have less to spend on other goods, gradually reducing the demand for goods & services which drives down prices.
What does this mean for your money?
It might seem counterintuitive to raise costs on mortgages to save money on goods & services, but all else being equal, the insidious impact of inflation is to lower the real value of your money over time. In the short-term it might seem unpalatable to see the amount spent on debt rise, but the avoidance of long-term levels of high inflation or hyperinflation is key to the Bank of England’s monetary policy.
The worst example in the U.K.’s history of the impact of long-term high levels of inflation was the 1970s, where inflation stayed above 7.6% for the entire decade. To put that into perspective, £100 cash on the 1st of January 1970 was worth about £24 on the 31st of December 1979.
Cash is only one of the various assets impacted by inflation and considering how your investments (typically Bonds and Shares) will react should also be considered:
Historically, shares have offered better protection against inflation than bonds or cash. However, increasing your allocation to shares at the expense of bonds or retaining money in cash increases the volatility of your portfolio. It makes little sense to take on undue investment risk to avoid inflation risk.
What should you do?
If this article has inspired any further questions, or if you wish to discuss your personal situation further, please get in touch.
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