This week economists were surprised when inflation was lower than expected at 2.4%. And this started me thinking about inflation as a concept, was it good, bad or even necessary?
As a child I used to think inflation was all good – I assumed everyone has a bigger mortgage than their savings. And yes, that’s a very biased middle-class assumption, assuming that everyone followed the same model as my (parents) life. But now as a quasi grown-up, my opinion is changing – is inflation a friend or foe?
What is Inflation?
Simply put, inflation is when over a time period prices of goods and services rise and thus purchasing power of currency diminishes. Economists agree that some inflation is good for an economy, but too much inflation is bad. In the UK, the Bank of England is charged with maintaining inflation at 2% – the government’s desired target. They achieve this by managing the interest rate (base rate) and fiscal stimulus.
In recent memory, after the 2008 crash, we have been through a period with minimal inflation and record low-interest rates. However, with the economy picking up and the impacts of Brexit, inflation is back in the UK. If you want the official figures, minus any commentary you can get them all from the ONS, the government department charged with collecting them here: Office for National Statistics: Inflation.
The majority of people think of inflation in terms of purchasing power when buying goods and services. That £10 you have today that buys you 10 loaves, will only buy you 9 loaves in the future. This simple economic concept is well understood, and we have easily understandable measures such as the RPI (retail price index) and CPI (consumer price index) that are calculated, published by the ONS and publicised widely in the media.
These indices are prepared by composing a standard basket of goods and tracking the prices over time. The RPI is currently higher than the CPI, as the RPI accounts for housing costs (e.g. mortgages and council tax) in addition to the consumer purchases included in the CPI. Their respective calculations also differ and if you want to know more, this is a great article from MoneyWeek.
Changes in industrialisation, manufacturing and consumption habits over the passage of time result in some goods becoming more expensive and others becoming cheaper. Hence the amount you are personally impacted depends on your individual consumption habits – hardly anyone buys the standard basket of goods used to create the CPI index.
And you can make this work to your advantage – by varying your tastes and moving towards goods that are decreasing in price. I know I certainly review my consumption habits then naturally gravitate towards cheaper alternatives. Are you willing to be flexible to realise these savings?
Erosion of cash value
The decreasing purchasing power of cash should be a big concern for people. Especially given not many people store their savings in inflation proof accounts. Here in the UK, you have not been able to get a savings account with a return over inflation for many years. Yet a large percentage of the population keep cash in savings accounts and do not invest in shares and bonds. This leaves their savings losing value over time. It’s a big concern, especially in periods of inflation and low-interest rates which leaves them exposed. The value of their cash savings will depreciate in real terms year upon year.
If you want to invest for the long term and want your money to retain its value, you need to invest in shares and bonds. The long term performance of cash versus shares in the UK can be seen in this fabulous Monevator article, where he also makes the case to invest in shares.
A key part of my journey to financial independence was learning about investing, you can read about my evolution to an investor. As inflation will erode the value of cash savings, I don’t keep any funds in a savings account. All my money is working for me in the market.
NB: This is made possible by my high savings rate that allows me to cashflow the vast majority of expenses that could come up. And not necessarily recommended for others in different situations.
Another fabulous effect of inflation is eroding the value of today’s debt in the future. As goods and services increase in price, debt remains the same price, hence the value of it reduces. This is one of the main reasons I am keen to retain my mortgage. Although I am in the fortunate position to be able to pay it off if I wanted to tomorrow. I will not, as the interest rate on my mortgage is tiny (1.5%) and I know inflation will erode its value.
Even looking back at my mortgage history – I took this mortgage out for £185k which felt like a massive amount of money at that time. But today, seven years later that £185k feels much smaller. Not to mention my income has increased tremendously to also dwarf the mortgage payment.
One I don’t see many people covering, possibly as it is very complex is how the concept of inflation will impact your FIRE numbers. Does your FIRE target go up every year with inflation? Do you expect to spend more in the future?
Personally, I am keeping my FIRE target constant; mainly as I am only two or three years away, and frankly I am too lazy to change it. Moreover, despite the inflation of the last few years, I have actually reduced my spending and absorbed any price increases with no impacts.
Friend or Foe
To conclude, given my personal situation I feel that inflation is a friend to me. It erodes the value of my mortgage debt which is a big win. And as I invest rather than save, I can easily avoid the value of cash savings devaluing. And for the triple, as I am flexible in my consumption habits, I can avoid some of the price increases.
But on the other hand, my social conscious does wonder about those less fortunate. I can’t help but feel that inflation is a foe to others, especially those on fixed incomes and that keep cash savings.
Over to you
- What are your thoughts?
- How do you think of inflation?
- Are you comfortable keeping money in cash?
- Do you feel inflation erodes your debt?