What does inflation mean for me and my money?

Kim Jones
Kim Jones
Updated 26 August 2022  | 3 mins read

Key points

  • If the rate of inflation is higher than the interest rate you receive on your savings, your money will lose value over time
  • Compare savings rates regularly to try to ensure you put your money in an account that beats the rate of inflation
  • In times of high inflation and low interest rates, if you have money you can put aside for five years or more, it might be better to invest it

What is inflation?

It’s the rate at which prices rise over time.

When inflation goes up, it generally means that the cost of living rises.

So, if inflation is at 3%, things cost an average 3% more than they did a year ago.

Put simply, if the cost of half a dozen eggs was £1.00 a year ago and inflation is running at 3%, the eggs will now cost £1.03.

If your wages don’t keep up with inflation every year, you’ll have less purchasing power and will find that your finances don’t stretch as far as they did in previous years.

The government sets The Bank of England a 2% inflation target to keep it low and stable. The main way it tries to hit this target is by setting interest rates.

How is inflation measured?

Every month, the Office for National Statistics (ONS) collects around 180,000 prices of about 700 items people regularly buy.

It includes everyday things like bread, milk and bus tickets, plus cars and petrol.

The price of the basket of goods is known as the Consumer Prices Index (CPI).

To calculate the rate of inflation, the ONS compares the cost of the basket (the CPI) with what it was a year ago.

This measure of inflation is used to set things like the state pension and benefits.

CPI or RPI?

You may come across the terms CPI and RPI when inflation is discussed.

CPI is the consumer prices index and RPI is the retail prices index.

Both are used to calculate, or measure, inflation and how much the cost of goods and services rise over time.

They both track the changing cost of a fixed basket of goods and services. But the RPI also includes the cost of housing (mortgage interest and house prices, for example) in its measure, so often comes out higher than the CPI.

The CPI and RPI also use different methods to calculate the index. The CPI uses a geometric calculation and the RPI an arithmetic calculation.

The CPI is the measure of inflation that the Bank of England targets.

What does inflation influence?

The government sets the Bank of England an inflation target rate of 2%.

Keeping inflation low and stable like this helps everyone better plan their savings and spending as they’re more confident about how far their money will stretch.

A moderate, stable rate of inflation encourages people to spend or invest, which helps the economy to grow and prosper, creating more jobs.

A higher rate of inflation means that money won’t stretch as far and people are less likely to spend on non-essential items and services, as well as investing less.

What does inflation mean for your savings?

If you have £1,000 in savings sitting in a shoe box under your bed (or in a bank that pays no interest), inflation will reduce its value over time.

This means that after, say, 15 years, although you’ll still have the full £1,000 it will buy you much less than it would have at the start.

Depositing your money into a savings account that pays a good rate of interest can protect the value of your savings.

But if the rate of inflation is running higher than the interest rate you receive on your savings (after tax), your money won’t grow and may even be losing value.

Because of this it’s wise to regularly compare savings rates to make sure you put your money away in an account that beats the rate of inflation.

Why do inflation rates change?

Inflation rates change year by year and even month by month, depending on supply and demand in the economy and the rise and fall in prices of goods and services.

Inflation currently stands at 9.1%, the highest rate since 1982. It’s so high mainly because of big increases in the price of global energy (oil and gas) and food due to supply chain disruptions caused by the pandemic and the war in Ukraine.

How can I protect my finances from inflation?

To prevent inflation from eating away at the value of your savings, you can:

  • Put away your money in savings accounts that pay interest at or above the inflation rate
  • Use your cash Isa allowance to save tax-free
  • If you have a bonus or special introductory rate savings account, keep an eye on the rate and switch to one that pays more interest when the offer period ends

How can you get an interest rate that keeps up with inflation?

With the current rate of inflation at 9.1%, a 40-year high, even the best savings accounts with top-paying interest rates are unlikely to beat inflation.

Here’s where you may consider investing as an alternative to saving.

Investments like stocks and shares ISAs, funds and bonds - where you put away your money for the medium to long term - give your money a better chance of growing and beating inflation.

But you need to be aware of the risks. Any investment like this can fall (as well as rise) in value. You could get back less money than you initially invested.

But in general, the longer you invest your money for, the more likely it is to grow in value and to recover from setbacks along the way.

It’s wise to have an emergency fund in place to cover around six months of expenses before you consider investing and you should be prepared to leave your money in place for at least five years.