The threat of inflation
Bank accounts are often viewed as one of the safest homes for your money.
But what happens if we take price rises into account?
Inflation is a term commonly used to describe increases in the cost of goods and services. It is often bandied around in politics and the media with little further explanation than this – and yet depending on the context, it can be either a good thing or a bad thing.
If you own your home, and your region experiences a period of house-price inflation, that could well be a good thing for you (less so for people trying to get on to, or move up, the property ladder).
But if the overall rate of inflation in the economy is growing at a faster pace than your savings, that is almost certainly a bad thing for you. This is because the money you have put in a bank account, or invested, would buy fewer goods and services than it previously could.
This is best understood in terms of cold, hard pounds.
Let’s take an extreme example: if you were to put £100 under your mattress for a rainy day, and inflation runs at 2% annually, you would need to add the equivalent of another £2 in today’s terms to your stash after every year to enable it to keep its purchasing power.
Or – in a more probable eventuality – if that £100 were placed in a bank account, it would need to earn interest of at least 2% to cancel out the impact of price rises.
To demonstrate just how potent the threat of inflation can be, let’s return once more to the mattress scenario. The following chart shows how much your £100 would be worth over the course of 10 years under different inflation rates.
Purchasing power pounded
After 10 years with inflation at 2%, you would only be able to buy £82.03 worth of the things that you could have originally bought with £100; with inflation at 4%, that sum would shrink to £67.56; and with inflation at 6%, its purchasing power would shrivel to £55.84.
As we pointed out earlier, not all types of inflation are terrible. But these stark figures show that if you want your savings to retain their value – and even grow – it is worthwhile looking at ways to generate returns over and above increases in the cost of living.
Please remember that the value of your investment and any income from it is not guaranteed, and can fall as well as rise. You may get back less than you invest.