How Inflation Really Works and Why it Goes Both Ways

Inflation has never been a hotter topic than it is right now. If you’d stopped anyone in the street anytime over the last 10 years and asked them what the current rate of inflation is, you’d get a lot of funny looks and probably no correct answers.

Right now? Everyone will know what you’re talking about, have a lot to say on the topic and will probably give you the headline figure within a couple of percentage points.

Inflation increases the costs of everything we buy, and it reduces the purchasing power of our salaries and our savings.

It's why there has been so much talk about ‘The Great Resignation’, ‘quiet quitting’ and also one of the main reasons there have been so many strikes and industrial action recently. It’s cut across all sorts of industries from bus drivers to Royal Mail with even suggestions of NHS doctors joining in.

What’s not quite as common knowledge is that inflation works both ways. While it causes savings to go down in value in real terms, it also does the same to debt. That’s right, over a long enough period of time, debt like your mortgage goes down in real terms, even if you only pay the minimum.

Now don’t get too excited. We’re not saying you shouldn’t pay off debt. But let’s get into this concept and give you a perspective on inflation you probably haven’t heard before.

Inflation Recap

Before we dive into the other side of inflation, let's make sure we’re on the same page with the fundamentals.

So what is inflation? It’s the general rise of prices for goods and services across the entire economy. It’s the reason why you used to be able to buy a family car for £2,000 or a Cadbury's Freddo for 10p.

The rate at which inflation increases (or rarely, decreases) is based on a huge number of economic factors such as interest rates, consumer demand, unemployment rates, supply chain disruptions and energy prices.

In simple terms it comes down to supply and demand. If there is more demand for goods and services than there is supply available, prices go up. If there are more goods and services available than there are customers looking to buy, prices go down.

We’ve seen a very stark example of this throughout the Covid pandemic. With factories across the world shutting down and people unable to travel easily across borders, the global supply chain ground to a halt.

It meant that things like microchips weren’t being manufactured, which had a massive impact on all sorts of electronic devices like laptops, phones and even cars. Because there was a shortage, there was more demand for these items than there was available supply, so prices went up. A lot.

Inflation can happen when the economy isn’t working properly for one reason or another, but it can also happen if the economy is working a little too well.

In boom times, companies grow quickly in order to keep up with demand. This can mean there is competition for things like workers and materials. It means employees can ask for bigger salaries and wholesalers can ask for more for their materials.

All of this bids up prices which increases the overall rate of inflation.

Quick example before we move on. Say a bottle of Coke costs £1 and you have £10,000 in the bank. Your ‘wealth’ buys you 10,000 bottles of Coke. 

If inflation on Coke was at 5%, it means that next year that same bottle would cost £1.05. Assuming you’ve not received any interest on your money in the bank, your £10,000 will now only buy you 9,523 bottles of Coke.

So you’ve still got the same £10,000 in the bank, but you’ve become ‘poorer’ because your money buys you less stuff or a lower standard of living.

This is why it’s so important that your income and your assets grow, in order to maintain (and hopefully improve) your purchasing power to allow you to live a better life.

So Is Inflation Bad for the Economy?

In short, no. While runaway prices are something that everyone wants to avoid, some inflation is a good thing. Rising prices creates an incentive for people and businesses to spend, grow and innovate.

If you could just stack cash in the bank and didn’t have to worry about inflation eroding it away (don’t worry, we’ll get into how this works later), there wouldn’t be as much need to find good investments or take risks with business.

In fact, if there was no inflation the economy could hit what’s known as the “Paradox of Thrift”. This theory suggests that if prices were to fall for an extended period of time, consumers would be likely to hold on to their cash to wait for a better deal.

This means less spending which means less demand and less economic activity. This then flows to fewer jobs which in turn leads to less spending again. It’s a negative loop that no country wants to be in. 

With that said, too much inflation is definitely not good. If prices rise too quickly, regular people's incomes and savings can get eroded away quickly and wealth can be destroyed.

How does the Bank of England impact inflation?

This is why central banks like the Bank of England and US Federal Reserve don’t aim for zero inflation, but rather a range that is generally between 2-3%. Inflation fluctuates all the time, but it tends to be relatively stable. The high levels we’re seeing right now are unusual, and between 1993 and 2021 inflation has almost always remained within the target range of 2-3%.

In order to try to keep inflation within this range, central banks pull the main lever at their disposal. Raising and lowering the base interest rate. 

The base rate is the level of interest that banks themselves pay. Because of this, all of the bank's products rise and fall with the base rate. It means that if interest rates go up, mortgages and personal loans get more expensive. It also means that interest on bank accounts and fixed deposits go up as well.

This works because raising or lowering rates impacts the way people spend their money. If mortgages get more expensive, people have less money in their pocket to spend on other things. Lower consumer spending means businesses have less demand and as we explained earlier, that keeps prices down.

Higher rates also flow through to savings and Fixed Deposits, which further incentivises reduced spending, as saving becomes more attractive.

If rates go down, the opposite happens. It gives households more money in their pockets to spend and less incentive to save. 

How Inflation and Investments Interact

When it comes to investments it’s important to keep in mind that some of the growth achieved will be ‘stolen’ by inflation.

If inflation rises by 5% and your investments ride by 5%, you haven’t actually improved your wealth. Going back to our Coke example earlier, you need to grow your funds by at least 5% in order to be able to buy the same number of Coke bottles.

Because of this, there are often two different returns figures that are quoted in investment circles. The first is gross return which is the headline number that your investment value has grown by.

If you have a portfolio of stock worth £100,000 and it grows to £110,000 then your gross return is 10% for that year.

The next figure is what is known as your real return. This takes into account the impact of inflation to provide a number that estimates how much your wealth has grown in ‘real terms’ once the impact of inflation is taken into account.

So in this example if inflation was at 3% for the year, the real return on that investment would have been 7%.

Gross Return (10%) - Inflation (3%) = Real Return (7%)

This is why Financial Advisors speak so much about the need to grow investments above the rate of inflation. If your portfolio is only just keeping pace with rising prices, or worse still not even keeping up, it’s not going to improve your quality of life and give you greater financial freedom over time.

How Inflation Impacts Debt

What’s not often discussed is that inflation erodes debt as well. Just the same way a pot of money you have sitting in the bank will fall in real terms, an amount of money you owe the bank will fall in real terms too.

Again, an example is probably the easiest way to explain this.

Say you have a mortgage of £500,000 and you are paying this back on an interest only basis. That is, you’re not paying back any of the owed amount right now, you’re just covering the interest payments.

Next year, you will still owe the bank £500,000.

But if inflation rises by 5% over that year, the real value of £500,000 has actually reduced by £25,000. So as long as the rest of your financial situation has improved (i.e. your income and your assets), the debt you owe actually falls in real terms over time.

This is a distinct difference between the messaging often found on blogs and social media accounts which suggest avoiding debt at all costs. Financial Advisors, on the other hand, understand that some debt isn’t necessarily a bad thing.

That’s not to say you shouldn’t endeavour to pay off debt. High interest debt like credit cards are a totally different ball game and you should clear those as soon as you can. But for lower interest, longer term debt such as your mortgage, there are potentially other options to consider rather than just piling all your excess cash into your mortgage.

This is just an overview on this topic, and there’s a wide range of factors that can impact the best course of action for any one individual. If you want to gain a snapshot of your own financial circumstances, we offer a number of tools through our app that can help.

Seriously, they’re incredibly useful and you’ve probably never seen anything like it before. You can download it for free and try it for yourself.

If you’d rather chat through your circumstances with a professional advisor you can book in a time for an initial discussion here.

Please note that this is not a financial advice and it does not take into account individual circumstances. Please also contact a professional advisor prior to any decision making.

The value of an investment and the income from it can go down as well as up and investors may not get back the amount invested. This may be partly the result of exchange rate fluctuations in investments which have an exposure to foreign currencies. You should be aware that past performance is no guarantee of future performance.