From savings to shopping, will higher inflation ruin your finances?

What it means to you, as the Bank of England predicts prices are set to rise by 4%, the highest in years

When the Bank of England announced on Thursday that it had left interest rates on hold at just 0.1%, it made a prediction about inflation. The rate of price rises would increase in the near-term it said “and is projected to rise temporarily” to 4% in the winter.

This would put it at its highest rate for 10 years, and would be double the level the Bank is tasked with targeting. After that, it forecast inflation running at 3.3% in a year’s time, 2.1% in two years and falling back to 1.9% by the summer of 2024.

What is inflation?

It’s the measure of how much prices are rising and falling and is tracked by several different indices. The Bank’s forecasts use the consumer prices index (CPI), which records the cost of a basket of 700 items including food, transport and entertainment.

It said the economic recovery, linked to easing Covid restrictions, “has led to higher energy and goods prices, which, in turn, reflect rising commodity prices, transportation bottlenecks, constraints on production and strong global demand”.

In June, CPI hit 2.5%, driven by rises in the cost of food, secondhand cars, clothing, bikes, books and fuel. The Bank suggests some of those will continue to rise over the next few months – bad news for those on a fixed income already struggling.

Moderate inflation is not a bad thing – people will be more likely to spend their cash if they think it will buy less in future. But high inflation has consequences.

What if you are saving?

Rising inflation at a time when interest rates are low is bad news – your money will not have the same buying power when you withdraw it as it did when you put it away.

If the Bank’s predictions are right, £100 in an account paying no interest will be worth about £91 in three years. “With the top easy-access cash account paying 0.6%, savers need to question whether they need all the money in cash,” says Laura Suter, head of personal finance at investment firm AJ Bell. “At that rate, and if inflation hits 4%, savers will pay £34 a year on every £1,000, just for keeping it in cash.”

Moving into higher-risk investments is a way to try to beat inflation, but there is always the chance that you could lose money too. “Equity income funds offer average income of about 3.5%, not far off a 4% inflation rate but, importantly, provide the opportunity to grow as well as offering capital gain over the longer term,” says Susannah Streeter, senior investment and markets analyst at Hargreaves Lansdown.

If high levels of inflation stay for longer than anticipated, the Bank may raise interest rates, good news for those with cash on deposit.

What if you are borrowing?

The opposite is true for borrowing. If you have a loan on a variable rate of interest, then a rise in the Bank base rate would push up your repayments. Fortunately, many people have opted for fixed-rate mortgages and costs will remain the same.

And inflation reduces the size of your debt in real terms. If it leads to a pay rise, then the sum you need to repay each month will be less of your income than when you first took on the loan.

What about pay?

Most workplaces do not have to raise pay in line with inflation, but it is often used in negotiations. Employers, who in some sectors are already battling with staff shortages, may have to increase wages to attract and retain workers.

And pensions and other benefits?

A number of benefits are linked to inflation, including the state pension. Under the triple lock, pension payments are set to rise in line with CPI if it is above wage growth, or 2.5%. However, the government has hinted that it could cut the link because wages are growing rapidly.

September’s figure determines how much elements of universal credit and other benefits will go up next April, so they should keep up with rising costs. However, before then, the temporary £20 a week universal credit uplift will have gone.

Some private pensions do have payments linked to inflation, so should go up.

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