Inflation is when the prices of everyday goods and services go up over time. When inflation rises, your money loses purchasing power. This means the same amount of money buys you less than it did before.
The Bank of England sets a target to keep UK inflation at 2% each year. This change affects both saving and investing. Because the value of money can change, it is important to know how to protect it over the long term.
This guide explains:
- What inflation is and how we measure it
- What causes prices to rise
- How inflation impacts your cash savings
- How inflation affects different types of investments
- Practical ways to help manage your money during inflation
What is inflation and how is it measured?
Inflation is the rate at which prices of goods and services increase over time.
A loaf of bread costs £1 in one year and then costs £1.05 the next year.
Inflation on the price of bread is 5%.
The UK government measures inflation by tracking the prices of hundreds of everyday items. This includes food, clothes, petrol, and cinema tickets. The Office for National Statistics (ONS) checks how these prices change monthly.
They use two main measures to show this change:
- Consumer Prices Index (CPI) measures the average change in prices for everyday goods and services.
- Consumer Prices Index including owner occupiers’ housing costs (CPIH) measures the same things as CPI. But it also includes the costs of running a home, like council tax.
H3: What does the rate of inflation mean?
The inflation rate measures the average change in the prices of a basket of goods and services compared to the same period a year earlier. Some prices may rise by more than the inflation rate, while others may rise by less or even fall.
The table below shows how a regular basket of goods can become more expensive over time if inflation stays at 3% each year.
| Year | Cost of the same basket of goods |
| Year 1 | £100.00 |
| Year 2 | £103.00 |
| Year 3 | £106.09 |
Inflation occurs when prices rise across the economy over time. Prices can increase for a variety of reasons, including changes in supply and demand, rising business costs, and disruptions to the supply of goods and services.
The main causes of inflation include:
What causes inflation?
- High demand (demand-pull inflation) happens when people want to buy more goods and services than businesses can supply. Because of a shortage, businesses can raise their prices.
- Rising costs (cost-push inflation) canhappen when it’s more expensive for companies to manufacture products. If raw materials or energy prices increase, businesses often pass these higher costs on to customers by raising prices.
- Wage growth: When businesses pay higher wages, they may increase the prices of their goods.
- Supply chain disruptions: Shipping delays can mean fewer products are available. This may drive up prices.
A mix of these factors often happens at the same time to cause inflation.
How inflation impacts cash savings
Inflation impacts cash savings by reducing the real value of your money over time. If the prices of goods rise faster than the interest rate on your savings account, your money can lose purchasing power.
For example, Alex has £10,000 in a traditional savings account that pays 2% interest. After one year, their balance grows to £10,200.
However, if the inflation rate during that same year is 4%, on average, the things Alex wants to buy now cost 4% more. This means they would need £10,400 to buy the same items that cost £10,000 a year ago.
Even though Alex’s bank balance went up, their money could actually be worth less in reality. Cash savings can be affected by inflation if the interest rate earned is lower than the rate of inflation. Over time, this may make it more difficult to achieve long-term financial goals if savings do not keep pace with rising prices.
If you’d like to build your finances over the long term, you might consider options beyond standard bank accounts, such as Shepherds Friendly Investments.
How inflation affects investments
Different types of investments respond to inflation in different ways, with some holding their value better than cash.
When you invest, you put your money into assets like shares or bonds to try to grow your wealth. Here is how inflation usually affects different types of investments:
- Shares (stocks): A share represents a small piece of ownership in a company. When inflation rises, some companies can raise their own prices to cover their higher costs. This can help keep the company profitable, which may help the share’s value grow.
- Bonds: A bond is a loan you make to a government or a company. Many bonds pay you back a fixed amount of interest.
- Stocks and Shares ISAs: An Individual Savings Account (ISA) is a tax-free way to hold investments. A Stocks and Shares ISA aims to grow your money without having to pay UK income tax or capital gains tax on any returns. This means you can keep more of any investment growth, which may help your savings keep pace with inflation.
Remember that all investments can go down as well as up in value. You could get back less money than you put in. Investment growth is never guaranteed.
Real returns vs nominal returns explained
A nominal return is the amount of money your investment earns before inflation. A real return is the actual growth of your money after inflation is considered.
To understand how your money is performing, you should look at the ‘real return’. This shows you whether your money is gaining or losing purchasing power.
Here is how to calculate a real return:
- You make an investment that grows by 6% in one year. This 6% is your nominal return.
- During the same year, the inflation rate is 3%.
- To find your real return, subtract the inflation rate from your nominal return (6% – 3% = 3%).
Your real return is approximately 3%. Investors focus on real returns for long-term goals, as it shows how money grows over time.
Strategies to protect your money from inflation
No financial strategy can remove the risk of inflation, but there are steps you can take to help protect your money.
Managing your money carefully can reduce the impact of rising prices. You can consider these practical steps to help protect your money:
- Invest regularly: Putting money away every month allows you to buy investments at different prices. This can smooth out market ups and downs over time.
- Diversify your money: Spreading money across different types of investments, such as shares, bonds and property, may help reduce risk. Different assets can perform differently in varying economic conditions, including periods of inflation.
- Invest for the long term: Keeping your money invested for five years or more may help it recover from short-term price drops and outpace inflation.
- Use tax-efficient accounts: An ISA can help you keep more of any returns by shielding investment growth from certain taxes.
- Check your savings rates: Review your bank accounts regularly to make sure you are getting the best interest rate.
Your strategy depends on your own financial situation and how much risk you are comfortable with.
The role of investing vs saving during periods of high inflation
Saving and investing have different purposes in a balanced financial plan. Saving is best for short-term goals, while investing is often better for long-term growth.
The table below outlines the main differences between saving and investing during inflation.
| Purpose | Saving in cash | Investing |
| Best used for | Emergency funds and short-term goals under 5 years. | Long-term growth and future planning for 5 years or more. |
| Risk level | Low risk to your initial deposit, but potentially lower real returns over time. | Higher risk as value can go down, but potentially lower real returns over time. |
| How it grows | You earn a fixed or variable interest rate from a bank. | Capital growth and potential dividend income (or company payouts). |
Both methods are useful. You may need cash savings for security and emergencies. But you might look towards investing to beat inflation in the long term.
If your investments pay dividends, it is helpful to understand how these are taxed. Find out more in our guide on dividend tax.
Long-term vs short-term impact of inflation
The effects of inflation can build up over time. Even low inflation can reduce the value of your money over decades.
A small price rise might not seem important in the short term. Over time, the combined effect is clear:
- 1 year: At a 3% inflation rate, a £100 shop will cost £103 next year.
- 20 years: If inflation stays at 3% every year for 20 years, that same £100 basket of goods will cost around £180.
This compounding effect means that keeping large amounts of money in cash savings for decades can reduce your purchasing power. Consider inflation when planning for retirement or long-term goals.
FAQs
What is inflation?
Inflation is the rate at which the prices of goods and services rise over time. It can reduce how far your money goes.
What causes inflation?
Inflation can be caused by several factors, including high consumer demand, rising business costs and supply chain issues.
What does the rate of inflation mean?
The rate of inflation shows how much more expensive on average goods and services have become compared to the same time one year ago.
How does inflation affect savings?
Inflation reduces the real value of savings. If prices rise faster than the interest rate on your bank account, your money buys less.
How does inflation affect investments?
Different investments react differently to inflation. Shares may grow as companies raise prices. Fixed-income assets like bonds may lose value in real terms.
Can investing help protect against inflation?
Investing can help protect against inflation because assets like shares may grow faster than rising prices, though this is not guaranteed and carries risk.
Is inflation always bad?
A low, stable inflation rate (such as the UK target of 2%) is generally seen as a sign of a healthy economy. High or unpredictable inflation harms consumers and savers.
What is the difference between real and nominal returns?
A nominal return is the total percentage gain of an investment, while a real return is what’s left after you subtract the rate of inflation.
Summary
Inflation is the gradual rise in prices over time, which can reduce purchasing power.
Here are the main points to remember:
- Savings can lose value if interest rates are lower than inflation.
- Investing carries risk, but assets like shares may have the potential to grow faster than inflation over the long term.
- Real returns measure what your money actually earns after accounting for inflation.
Explore Shepherds Friendly’s investment options to see how our products could support your long-term goals.
Please note: No advice has been given by Shepherds Friendly. If you are unsure about the effects of inflation or which savings product is suitable for you, you should contact a financial adviser. There may be a charge for financial advice, and the cost should be confirmed to you before any advice is given.
