The Consumer Price Index (CPI) for July hit 10.1%; bringing UK inflation to a 40-year high (August’s figure remained almost as high, at 9.9%). Worryingly, this is five times the target for the Bank of England (BoE), and forecasts suggest that inflation could even reach 18.3% in 2023 - the highest rate in half a century - primarily due to higher energy prices, although we need to wait and see what impact the government’s price cap will have. Understandably, people across the UK are worried about what this means for their wealth and finances. Below, we explain what is happening in 2022 with inflation and outline some key implications for your financial plan.
What is inflation? A quick recap
Inflation refers, broadly, to the rising cost of goods and services in an economy over time. Many economists believe that a small amount of inflation can drive economic growth, which is partly why the BoE has an inflation target of 2%. However, if prices rise too quickly in an economy, it can cause problems. Firstly, consumers may struggle to afford essential goods (such as food items and petrol). Secondly, it can lead to higher “input costs” for businesses - such as materials for products - which then eat into their profits. If costs get too high and these cannot be passed down to customers, those businesses may be forced to cut jobs.
The inflation landscape in 2022
What is driving inflation at the moment? Rising average wages in an economy, for instance, can be a culprit as this means people have more money to spend, leading businesses to feel that they can charge more. In 2022, however, this does not appear to be the main factor. Indeed, the evidence largely suggests that wage growth in the UK has not kept up with inflation - leading an average worker £20,000 worse-off, in real terms, since 2008.
Rather, the primary driver in 2022 seems to be rising energy costs. Wholesale prices were rising already in 2021 as countries reopened from COVID-19 lockdowns. Also, Europe and Asia both experienced an especially cold winter - leading to a depletion of gas reserves and high demand to refill them. Since February 2022, however, we have also seen Russia’s invasion of Ukraine - leading to heavy international sanctions on the former, which is a major producer and supplier of oil and gas to global markets. It is expected that the recently announce government plans to cap the energy costs of households will have some impact on reducing inflation, although we need to wait to see the full impact.
How rising energy prices are driving up other prices
Unfortunately, rising energy prices do not just lead to a higher bill at the pump. Supermarkets, for instance, rely on lorries to deliver goods to their shelves. Higher transport costs erode their margins, which then get passed down to consumers in the form of higher prices. According to the ONS, for instance, the average price of an 800g loaf of bread is now £1.24; which is 18p higher than last year. Moreover, plastic goods (e.g. toys and soft drink bottles) are often made using natural gas. Higher gas prices increase the input costs for items such as these, which - again - get passed down to the consumer. Modern cars are also often made using high amounts of plastic. The Tesla Model S, for example, is partly made using petrochemical-based plastic. In short, higher energy costs have a big knock-on effect to consumer spending, overall.
Short-term financial planning implications
Given the harmful effects of high inflation, the BoE is keen to get the CPI rate back down to 2% (“normal” levels). Its primary tool to achieve this raising the base rate, which other UK banks use to set their own interest rates. When the rate goes up, so do theirs. The BoE has raised the base rate six times already since late 2021 to try and control inflation - from an all-time low of 0.10% to 2.25% at the time of writing. However, inflation shows no sign of reversing yet and there are hints that the BoE may be forced to raise the base rate to 4% (or even more) in 2023.
One of the most pressing implications of increasing interest rates is your mortgage. Those on a variable rate will likely see their monthly payments go up. One report suggests that those who took out a 2-year fixed-rate deal in 2020 during the pandemic (when rates were very low) may also be in for a shock when their deal expires in the coming months. The market has shifted a lot due to the higher base rate, with the average 2-year fixed-rate deal now standing at 4.09% interest (in 2020, it was 2.45%). This could add £200 a month, or more, to some homeowners’ mortgage payments. To prepare for possible cost rises in this aspect of your finances, consider reviewing your budget and making sure that you can stay within your means.
Looking to the longer term
Over time, high inflation also degrades the “real value” of your savings and investments. If your portfolio grows 6% in a year but inflation rises by 2%, for instance, then it has grown by 4% in real terms (setting aside other costs and taxes). In 2022, interest rates on regular savings are still low and do not come close to matching inflation. Therefore, whilst it is wise to hold 3-6 months’ worth of emergency savings in an easy-access account, it is generally a bad idea to hold lots of wealth in cash - which will lose value over time.
Instead, consider reviewing your portfolio strategy with your financial planner to ensure that you take advantage of other assets and investments that give you better opportunities to match (or beat) inflation over the long term. Equities, bonds and property investments are all examples that you may consider in light of your financial goals, situation and risk tolerance.
Speak to us here at Punter Southall Aspire if you would like to discuss your position and how to reach your goals.