The basics of inflation

Why do we invest?

Many people have different reasons why they invest, one big driver is to save for retirement, as you may not want to work for your entire life. Another basic principle is to fight against the cost of rising goods and services in your economy, also known as inflation.

Inflation informs you how much the value of a dollar/pound has changed over time. When inflation increases, the price of goods and services also increases. Both your investments and the economy may be impacted in a number of ways by this.

Inflation reduces your purchasing power, meaning the same amount of money will eventually purchase less goods and services due to inflation. Deflation is the opposite, when there is a decrease in the cost of goods and services over time. You may have also heard of disinflation, which is a fall in the rate of inflation but there is still a general increase in the price of goods and services.

In economics, inflation is a measure of price changes per country. The Bank of England, who controls the supply of money, through the monetary policy in the UK has a target inflation rate of 1% to 3%. You might be wondering; “Why not target 0% inflation?” Why do we need to keep the cost of goods and services rising? One reason is 0% is close to deflation levels, which can do more damage to the economy than good, which can lead to a deflationary spiral. A modest increase in inflation can help the economy grow, but at a pace which can be affordable for people.

A good visualisation of inflation can be found using the Bank of England’s inflation calculator. £10 in 2000 would cost £18.63 in January 2025. An 80% increase in 25 years.

Investing helps protect our purchasing power from inflation by allowing our money to grow and maintain its value over time, ensuring a positive rate of real return.

 

Real Rate of Return

If the value of your investment rises, you could earn profits from your investment. Alternatively, if the value of your investment drops, you can incur a loss. The amount that your investments have gained or lost over time is shown by your rate of return.

Consider, for instance, that you had a £10,000 investment. It was worth £11,000 a year later. Ten percent of your initial investment, or £1,000, would be your nominal rate of return. Inflation, taxes, and investment fees are not included in the nominal rate of return.

The effect of inflation is taken into account by your real rate of return. In the previous instance, your real rate of return would be 5% (as opposed to 10% in the nominal rate of return example) if the annual inflation rate was 5%. If you take inflation into account, this would mean you would make $500.

Your real rate of return can also include taxes and investment fees. Inflation and other expenses like these are factored into your real rate of return. It provides a better understanding of the purchasing power of the money you earn from your investments.

 

How Inflation Changes Affect Your Investments

Inflation impacts your investments and the broader market in several ways. As costs rise, the purchasing power of your money decreases, leading to a lower real rate of return on your investments. This means you’ll need to save more over time to achieve your financial goals and may need to seek higher returns, which often involves taking on more risk.

Rising consumer prices can also affect company sales and reduce profits, potentially leading to lower dividends for shareholders. Additionally, industries hit hardest by inflation may struggle to remain profitable, causing investments in these sectors to decline in value.

 

How Inflation Changes Affect Interest Rates

The Bank of England’s role in the UK is to control the money supply within the UK, by changing the base interest rate to manage the inflation rate. This change in the base interest rate will affect lenders and borrowers by the change of cost, usually expressed as the annual percentage rate (APR).

Higher interest rates mean it costs more to borrow money, and lower interest rates will mean it is cheaper to borrow money. This affects individual borrowers, but it has a ripple effect on the way people invest, especially in the bond market.

When inflation is rising, interest rates may rise to combat the cost of living, to encourage more people to save rather than borrowing, which in turn leads to bond prices falling. For example, when your bond matures, the return you will receive on your bond investment will be worth less in today’s terms.

This can offer some insight into investing in shorter duration bonds. As a long-term investor, uncertainty is a certainty when it comes to investing. Second guessing if interest rates may rise or fall and timing this to your advantage can be regarded as a ‘fools game’. By holding shorter duration bonds, they provide capital protection (inflation protection) when markets become volatile, whilst giving us more liquidity than fixed deposits at a slightly higher return offered at a higher risk.

 

Investing serves as a safeguard against inflation by enabling your capital to grow, countering the diminishing purchasing power of money over time. As inflation increases, the cost of living rises, making it crucial to seek returns that exceed inflation rates through investments in stocks and bonds. This strategy not only helps maintain financial stability but also enhances the potential for wealth accumulation, ensuring that your money works harder for you in an inflationary environment.

To discover how we strategically build tailored portfolios for our clients and navigate inflationary challenges, visit our website or contact us today.