There are various ways to measure inflation but the basic idea behind them is much the same, inflation indexes track the changes in a basket of goods and services which is considered to be a good representation of how the average person spends their money. Of course, whether or not it is a good representation of how you personally spend your money, depends on how closely you fit the model of the “average person” and this can work both ways, in other words, you might find that your personal rate of inflation is higher or lower than the official measure.
The value of pensions and investments and the income they produce can fall as well as rise. You may get back less than you invested.
Inflation and income
There are essentially two ways inflation can influence income, one is direct and the other is indirect.
Direct - inflation as a measure for wage and pension increases
Employers can use the official rate of inflation as a convenient measure for determining annual, standard wage increases (i.e. wage increases which are unrelated to either promotion or performance). It also forms part of the current “triple-lock guarantee” on state pensions (i.e. that they increase by the rate of standard earnings, inflation or 2.5%, whichever is the greater).
Indirect - inflation as a parallel to interest rates
When inflation is low, if a central bank wants to try to stimulate the economy, it has a choice between lowering interest rates or using quantitative easing. If inflation rises, however, and a central bank wishes to put a gentle brake on the economy, then it really only has one tool at its disposal, which is to raise interest rates. This is good news for savers as it increases the interest income they receive but of course it is bad news for borrowers since it increases the amount of interest they need to pay and hence reduces their effective income.
A little inflation is seen as a positive
The Monetary Policy Committee of the Bank of England is charged with keeping inflation at exactly 2%. Of course, it’s very hard to make sure a moving target stays in exactly the same position, so the MPC is allowed 1% leeway either way before it is called to account for its actions. A reasonable level of inflation is seen as a stimulus, encouraging people to take action now rather than waiting for prices to rise further. By contrast stagflation (static prices) or deflation (falling prices) can both encourage people to put off purchases in expectation that waiting will either make no difference or might even be beneficial.
Incorporating the reality of inflation into your financial management strategy
In very simple terms, any investment decision you make must at least match inflation in order for you to break even and must generate returns which exceed the rate of inflation in order for you to make a profit. For example, in the current low-interest-rate environment, cash deposits in savings accounts are highly unlikely to make the sort of returns needed to beat inflation, although there may be other, perfectly valid, reasons for keeping them, in which case looking at strategies such as putting them in an ISA wrapper may be valid. By contrast, stocks in start-up companies may offer the prospect of massive returns - although there may be a very high level of risk involved with them.
The skill of balancing risk and reward is at the very core of successful investing and one of the key points which successful investors need to understand, is that sometimes the investments which seem the most safe can actually carry a high risk of their own, namely the risk of having capital devalued by the impact of inflation. This is not, of course, to say that investors should see this as a sign to dive into the higher-risk end of investment vehicles, just that they may benefit from opening their minds to investments they might otherwise have rejected out of hand for being slightly too risky for their tastes.