Inflation – Good Bad or Ugly
For the first time this century, we are facing the threat of inflation in double figures. In many ways, it is the perfect storm, caused by the rapid recovery from COVID-19, a shortage of workers and rising commodity prices due to the Ukraine conflict. The effects of inflation on you and your household will depend on your circumstances, and so inflation can be Good, Bad or Ugly for your household finances.
Good
The Retail Price Index (RPI) or the Consumer Price Index (CPI) are the two most quoted measures of inflation. Both are measured by looking at a basket of goods and services but with RPI including housing costs, it is more influenced by house prices and mortgage interest rates. The Office of National Statistics will review and adjust the underlying basket of goods and services to reflect changes in consumer patterns, but the truth is you are very unlikely to have a Personal Inflation Rate which matches either measure. For some people, therefore, they may find their income rises faster than their expenditure as often income is linked to either the CPI or RPI.
Inflation is also a good way of eroding debt over time, as the value of the underlying debt does not increase with inflation, so faster growth in income will reduce the burden of repaying a debt. The cost of servicing the debt may increase due to higher interest rates on mortgages, but assuming you can afford to service the debt, over time inflation can help reduce the debt in real terms. This is useful for individuals, companies and the government.
Bad
Your personal inflation rate may be higher than the RPI or CPI, so your income may not rise fast enough to meet your needs. In the same way as your debt is eroded, so is the value of your savings, especially if the level of interest paid is below inflation, which has been the situation for a number of years.
A further issue is the lag between rising prices and rising income. Your income is unlikely to increase each month, whereas the cost of goods and services does increase each month, so you face a drop in living standards in the short term until your income is increased.
Some companies will use inflation to justify an increase in the price of their goods and services by more than their underlying costs for profits. This is especially true of companies where they have pricing power, such as established brands, or where the demand for their product is not price sensitive, such as petrol.
The final reason why inflation is bad, is that the best way to control inflation is to raise interest rates to reduce demand and place downward pressure on prices. This will result in a slowing economy or even a recession. Whilst this may not directly affect us, the loss of jobs, rising unemployment and increased poverty is never welcome.
Ugly
The ugly side of inflation is where the damage is not just bad for your financial health, but also benefits third parties. There are two areas where this occurs – firstly, taxation and secondly, Final Salary Pensions.
Tax
Even if you are fortunate enough that your gross income rises in line with inflation, your net income will not increase as fast due to tax. The reason for this is that every additional £1 of income will be taxed at your highest marginal rate, not the average rate of tax paid on your income. Unless the government also increases your personal allowance and tax bands in line with inflation, they are benefiting from an increased tax caused by inflation.
Pensions
If you have a deferred pension with a Final Salary Scheme or a Final Salary Pension in payment, you should be aware that there are limits on the rate of increase in the pension. For older schemes, the cap is usually the lower of the Retail Price Index or 5%, whilst more recent schemes use the Consumer Price Index with a cap which can be as low as 2.5%. Even worse, some elements of your pension may not increase at all.
Therefore, if inflation remains at current levels, you may find that there is an enforced reduction in the purchasing power of your pension and when this is combined with the tax deduction if in payment, you can see why inflation can affect your lifestyle.
Actions: Inflation – Good, Bad or Ugly
Review your personal level of inflation
Look at how inflation is affecting your expenditure and whether you need to make changes. Reviewing bank and credit card statements is a good way of seeing what you are paying for goods and services and to whom. Once established, you may find that savings are possible by reviewing providers, changing your usage or even cancelling services which you don’t need or are no longer good value for money.
Review the level of cash held and where it is held
Holding excess cash during times of high inflation and low interest rates is not beneficial. Reviewing the amount of cash and where it is held is worthwhile.
If you do have excess cash, then you may wish to consider how best to use it. Whilst investing for higher returns is an option, you may also consider whether it should be gifted to help younger generations.
Review your Final Salary Pensions
If you have deferred Final Salary Pensions or a pension in payment it is important you review the level of increases. Whilst there is little action you can take to challenge the erosion of the value of the pension, it is better to be aware of how it is affected and if appropriate, take action to mitigate the loss of purchasing power.
If you have any questions on Inflation – Good, Bad or Ugly, please get in touch and we will happily advise you on your own individual situation.