Recently, you might have not paid much attention to the news that the UK inflation rate hit a two-year high in May. The rate rose from 1.5% in April to 2.1% in May, mainly thanks to a rise in the cost of fuel and clothing.
In historic terms the inflation rate remains low, and it’s only just over the Bank of England’s target of 2%. So, why does it matter that rises in the cost of living are accelerating?
Higher inflation means that your money doesn’t go as far, and it can threaten consumer and business spending at a time where a fragile, post-lockdown economy needs a boost. It can also have a longer-term impact on the standard of living you might enjoy once you retire.
Read on to find out more about why inflation is rising, what it might mean, and how it affects you.
Inflation set to exceed the Bank of England target later in 2021
According to Bank of England forecasts published in The Times, inflation will continue to rise sharply over the next few months. Prices will rise at almost 2.5% for a year from October 2021 – above the Bank of England’s 2% target.
Source: The Times
So why is inflation rising?
There are several reasons. Firstly, demand for goods and services has increased sharply now restrictions are easing.
According to the National Institute of Economic and Social Research (NIESR), UK households have saved around £160 billion over the course of the pandemic, with the Bank of England’s chief economist, Andy Haldane, predicting that as much as 20% of that could be spent by the end of 2021.
While demand has risen, there have been constraints on the supply caused by issues such as Brexit and Covid-19. The CBI’s latest manufacturing survey showed average cost growth in the three months to April was accelerating at its fastest pace since April 2011. And Brexit and the pandemic have created a perfect storm of reduced imports, limiting what is available in shops.
All this means that there is too much money chasing too few goods, and this pushes up prices.
A further complication is that the usual approach to rising inflation is for the Bank of England to raise interest rates.
However, the Bank are extremely reluctant to increase the cost of borrowing, as this would threaten any potential economic recovery. A rise in things like loan and mortgage payments could be catastrophic at a time when the economy needs businesses and households to be spending.
Why inflation matters to you
Of course, rising prices affect you in the short-term as your money isn’t going as far to buy the goods and services you want.
It can also mean that your cash savings are being devalued. According to analysis from Moneyfacts, there are currently no savings accounts that beat the current rate of inflation.
So, if your money is sitting as cash in a savings account, the interest you’re getting is lower than the inflation rate, and so your cash is losing value.
The effect of inflation can also be pernicious over the long term.
Imagine you’d decided that you wanted to retire in 20 years’ time on an income of £40,000 a year, and you’d saved up a big enough pot to do this.
Assuming inflation remains at the Bank of England’s 2% target, in two decades you’d need an income of £59,437 for it to be the same as £40,000 in today’s terms.
Source: CPI inflation calculator
This means you’d have to save around 50% more than you were expecting, just so your income in 20 years is the same in real terms as it is today.
Essentially, if inflation remained at 2%, you’d have to draw 2% more from your retirement fund each year to keep pace with rises in the cost of living.
So, when you’re thinking now about how much you have to save for retirement, it’s likely to be more than you anticipate. You must think ahead and save enough to maintain your lifestyle in real terms.
Of course, this is all assuming that inflation remains at 2% for the next 20 years. If it exceeds this, you’ll have to save even more.
As financial planners, we can help to mitigate inflation risk. We can use sophisticated cashflow modelling software that can consider the effects of inflation to determine whether you’ll have “enough” to live the life you want.
We can model different scenarios – perhaps at different rates of inflation – to establish whether your savings will be sufficient to last you for the rest of your life taking into account rises in the cost of living.
Get in touch
If you’re worried about inflation, or you want to be sure you’re saving enough for your retirement, please get in touch. Email firstname.lastname@example.org or call us on 01454 416 653.