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What is inflation and how does it increase living costs?

Here’s everything you need to know about inflation and how it affects you.

Inflation written on wooden blocks

We’ve all heard the term inflation and are told that it impacts our living costs. Certainly, we feel the effects of rising inflation, and benefit when inflation drops. But what exactly is inflation and how does it impact our pockets?

What is inflation?

According to the Bank of England, inflation is the measure of how much the cost of goods and services goes up over a period of time. Inflation is measured by comparing the cost of things at a starting point, and how much they cost at a set endpoint, i.e., compare costs between Q1 of the year and Q2, and the average percentage increase or decrease is known as the inflation rate.

For example, if the cost of a pint of milk was £1 in Q1 and £1.02 in Q2, the cost has increased by 2p and represents an increase in inflation of 2%.

The Office for National Statistics (ONS) collects approximately 180,000 prices on about 700 items, which they call their ‘shopping basket’, to calculate the Consumer Price Index (CPI), which is the targeted inflation measure. 

Is inflation good or bad?

The rate of inflation can be good for some and bad for others, depending on whether it is in line with the Government’s inflation target of 2%, which is the level that keeps the economy stable. If the inflation rates go up too much or there is a lot of movement in the inflation rate over the year, it makes it difficult for businesses to plan for the future in setting the right prices.

Who benefits from inflation?

If the inflation rate is low, it usually means the Bank of England’s base interest rate is also low. Therefore, people looking for loans or mortgages benefit from low-interest rates. However, savers suffer as they would rather have a higher interest rate to earn more on their savings. This also applies to pension funds because for the funds to increase, they need a higher rate of interest, too.

In terms of our everyday living costs, the lower the rate of interest, the lower prices will be for goods, such as our food, white goods and luxury goods, and services like train tickets and energy bills. Inflation rates above the Government’s benchmark of 2% – it currently stands at 3.1% – means the Bank of England will raise their base rate and businesses will increase their prices. Therefore, we will end up paying more for our goods and services.

Suppose you own stocks and shares, particularly in utility companies or popular consumer brands, infrastructure and real estate. In that case, you are likely to benefit not only in terms of the value of your investment increasing but also in dividend pay-outs as most of these companies base it on the rate of inflation.

How can I protect myself from inflation?

With the Bank of England’s Monetary Policy Committee predicting inflation to reach 4% by the end of 2021, double the Government’s target of 2%, now’s the time to take action to protect your savings, pensions and pocket from the impact of rising inflation. 

The likelihood of inflation dropping significantly over the next year is low due to the coronavirus pandemic. So, if you have money sitting in a savings account, now may be the time to invest in the stock market, in stable companies and corporations, or in the real estate market. You are more likely to see a better return on your investment this way than you would see in interest on your savings. 

Inflation has a big impact on long-term retirement savings and pensions, particularly those that have annuities at a fixed rate. Transferring to an inflation-linked annuity may mean paying more into your pension pot initially, but the income increases over a longer period of time. Those receiving a state pension will benefit from more money as it is linked to the inflation rate, although not as much as previous years as the Government scrapped their triple lock policy. 

There will also be an impact on the housing market so, if you are planning on moving house, opt for a fixed rate of interest over a 2, 3 or 5-year period. The inflation rate guides variable rates; when inflation is low, those with variable rates benefit, but as the rate of inflation rises, so does the interest rate.

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