Inflation, and its Effects on Savings and Investments

Posted on June 7, 2020

Inflation is the term used to describe the increase in prices for both goods and services in an economy, and the resulting devaluation of currency.

It is of particular interest to those saving or investing, because it allows them to calculate the actual rate at which their savings are growing, and the ‘real world’ value of any returns / income on their investment.

What causes inflation?

Economists are divided on the exact causes of inflation. These are all commonly given as contributory factors:

  • the amount of money in circulation (and people’s impression of its value);
  • rising costs for businesses (raw materials / goods, wages, taxes etc);
  • national debt (because the two most common methods to pay this off are raising taxes or putting more money into circulation);
  • increased demand for certain goods or services;
  • the cost of commodities seen to be essential (most notably, oil prices);
  • currency exchange rates if these make imported goods more expensive (and exported goods of lower value overseas).

Note how many of these factors create a ‘knock on’ effect on each other. For instance, if wages are higher and people have more disposable income this will increase demand for popular good and services. This higher demand will tend to create scarcity of supply, increasing value.

Measuring inflation

In the UK, the Office for National Statistics tracks consumer price inflation, producer price inflation and the House Price Index.

It is generally agreed that a rate of 2% for the Consumer Prices Index (or CPI) is healthy. Inflation that is too low or too high can cause economic damage.

Recent inflationary history

Inflation spiked in the third quarter of 2008 at nearly 5%, and then fell rapidly to 1% in a year. There was another spike of 4.5% in 2011 later and then a steady fall to record lows at the end of 2015, before beginning another steady rise.

In the UK, perhaps the biggest cause of concern that inflation might rise too fast is the falling value of the pound internationally and the extra cost of importing goods (for instance, Retail Analysts for HSBC estimated in January 2019 that 80% of the food eaten in the UK is imported).

Inflation erodes the real value of cash savings

With the certainty that money buys less over time, a combination of higher inflation and lower interest rates can see savings devalued when it comes to real world purchasing power. Recently, even the best interest rates available on Cash ISAs have fallen below the rate of inflation, even when money is locked away for two or three years.

Investments aim to stay ahead of inflation

Investments offer the potential to grow your savings at a rate that outstrips inflation, giving you more purchasing power in the future.

Not every investment generates a return, not every investor makes a profit, and it is possible to lose large amounts of money. However, the equities market as a whole comfortably outstrips inflation over time, even after huge downturns such as the 2007/8 financial crisis, due to the combined effect of share price rises and dividends paid by profitable companies.

This is not to say that investments are not affected by inflation: different assets will be impacted in different ways.

Bonds and inflation

A bond is a loan over a fixed period of time and at a fixed rate of interest to a company (or a government) looking to raise cash. In theory the bond holder should receive regular payments at a fixed rate (the ‘coupon’) and see the return of the ‘issue price’ (the amount of the loan) at ‘maturity’ (the date the loan becomes due). However only government bonds in stable countries are risk-free: bond-issuers in financial trouble can fail to pay interest at the quoted rate, and even fail to return all or any of the issue price.

Bonds may be re-sold after issue, leading to a secondary market, and the opportunity for collective and diverse investment via bond funds. However this secondary market also complicates matters by creating an additional valuation of the bond: market price, which can differ greatly from the issue price. The market price will depend on:

  • the coupon (and whether this has been honoured to date or not, and whether this is expected to continue or not);
  • the perceived ability of the issuer to return the issue price;
  • the time to maturity (because this effects the potential returns via the coupon).

An investment that has capped returns will obviously suffer when inflation is higher. Not only that, as high inflation often leads to an increase in interest rates across the board, older bonds with their fixed rate are going to be less desirable in secondary markets than newer bonds with better rates and longer time to maturity. Finally, the operations of the issuer might be impacted. This opens up the possibility of defaults on interest payments and a fall in the market price of their bonds.

Index-linked bonds

It is possible to purchase bonds where both the coupon and the return are tied to the rate of inflation: the UK government’s index-linked Gilts (commonly referred to as ‘linkers’) are one example. These can be more expensive, and the coupon is also usually lower.

Stocks & Shares and inflation

Investing in a small number of individual companies is rarely a sound strategy. Risk can be lowered by investing via a fund that will hold a wide range of different stocks. The most simple and well-known of these are ‘market tracker’ funds whose shares rise or fall in line with the index they track: the FTSE 100 in the UK and Dow Jones in the US are two notable examples.

Whatever the vehicle, investors hope that the company they hold stock in will be profitable, generating income via dividends and increasing the market value of their stock and so growing the value of their portfolio.

Rising inflation can impact the income from and value of stocks and shares in many ways. If inflation is high because of a strong economy, many companies will see increased demand for their products and services. However they are also likely to see increased costs. If companies with rising costs are not able to increase their prices accordingly, they may find their overall financial performance suffers. Ultimately it will depend on the sector the company operates in and its individual history.

Gold and precious metals

Currencies were at one point backed by gold, with different denominations serving as a promissory note for a certain sum in gold. These days no country in the world uses the ‘gold standard’: currency is created by central banks out of thin air. Some investors think that gold offers protection from inflation, not least because if the purchasing power of the pound falls then gold is worth more by comparison, but also because there is a finite amount of gold in circulation (or accessible in an economically viable way, which amounts to the same thing).

Property investing and inflation

Property costs have generally risen more than inflation, although this is not always the case: for example, the UK House Price Index shows that from December 2018 to June 2019 the average increase across all property types fell from 2% to 0.9%, whilst inflation has fluctuated between 1.8% and 2%.

As with the stock market, there are peaks and troughs and it is possible to lose money, but the general trend over time is upwards, and at a rate that outstrips inflation. Prudent investments and patience tend to be rewarded more often than not.

Becoming a landlord in either the residential or commercial sectors is quite a step to take. However there are property funds for both sectors, with the better commercial funds diversified across offices, retail and leisure centres and industrial estates.

Property funds can benefit from the fact that rents usually rise in line with inflation, and also from appreciation in property values. Furthermore, investing via a fund generally sidesteps property’s major drawback (its lack of liquidity). However this only holds true for the good times.

If the economy suffers then the commercial rental sector is hit harder than the domestic one (people always need somewhere to live, no matter what), and if there is a ‘run’ on a fund then managers have been known to ‘lock in’ investments to allow them time sell some of their holdings and generate the cash to pay off shareholders. A locked fund is going to see its share price devalued still further.

As always when investing, the best strategy is one that looks to the long term, is sufficiently diverse to ride out any ‘bumps in the road’, and is reviewed regularly with an eye to the current economic landscape.



No guarantee can be given that the information provided is accurate in the present or the future. It is not intended to constitute either a statement of applicable law or financial advice, and responsibility cannot be accepted for any subsequent loss following activity or inactivity by any individual or organisation. Indeed, such information should NOT be acted upon without first receiving appropriate and specific professional advice.