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Inflation, interest and investing - how is it all related?

In this article we explore the relationship between inflation, interest and investing and how they are all related.

In this article we discuss two driving forces behind why people invest: interest and inflation. We often see interest rate and inflation in the news, but how do these changes actually impact us personally and what can we do to protect the value of our savings? 

This article is the first in a series where we discuss investing, a topic that is more often than not associated with people who are older and have already ‘made it’. But, as we will discuss over the coming months, it’s important to start investing young - no matter how small your initial savings are.

Inflation

Inflation is a concept that most of us have probably heard of but perhaps few of us thoroughly understand. Put simply, inflation is the gradual increase in prices of goods and services over time. 

On one hand, inflation is annoying because it makes things more expensive; on the other, if prices are going up, then this may indicate that people have more money that they are willing to spend, which drives economic growth. 

Inflation is best understood through supply and demand. As we discussed in a previous article, when demand is greater than supply, prices increase. Therefore, if people have more money to spend on things, demand increases, which in turn causes inflation - this is common in growing economies. 

Historically, there have been periods of very high inflation. However, one effect of globalisation and in particular the opening up of the Chinese economy has been that the worldwide supply of goods has increased. This means that the gap between supply and demand is more easily met, which has a dampening effect on inflation.  

Traditionally, economists view inflation of around 2% as a sign of a healthy economy. So, assuming that inflation is running at 2% a year, something that costs £100 today will cost £102 next year. This means that the money in our pockets is worth more today than it will be next year - more on this in a moment.

Interest rates

Interest, from the perspective of an individual, is the cost of borrowing money and the return on saving money. Interest is often expressed as an annual percentage rate (APR) of the principal - principal being the size of your loan or the amount you deposit in a savings account. 

(One point to note here is that when we “save” money in a bank account, the bank will use our deposited cash in order to fund its various activities, such as mortgage lending. So, we are effectively lending money to the bank - which is why they pay us interest on savings.) 

Interest rates on borrowing can vary wildly. For example the interest rate on a mortgage may be less than 3%, whereas credit card interest rates are around 20% and payday lenders can charge over 1,000%! Meanwhile, banks pay savers as little as 0.01%!  

Understanding interest rates is vital in understanding the difference between how much money we borrow and the actual total cost of borrowing it. An example of where this may come in handy is when we compare different mortgage products. A bank may offer a 2.5% mortgage that is fixed for 3 years as a standard, but offer 2.3% if we pay an upfront fee of £1,000. The ability to weigh up those options to evaluate which is better for our personal financial situation is a valuable skill. 

Unlike inflation, interest rates are not set entirely by supply and demand. Central banks - such as the UK’s Bank of England and the USA’s Federal Reserve - set what is called the “base rate”. This is the rate at which regular banks can borrow money from central banks in order to subsequently lend to businesses or consumers like us. 

Therefore, if the central bank announces that it will increase the base rate, it’ll cost banks more to borrow, therefore, they will charge more to their customers to pass this cost on. 

When inflation is increasing (meaning that demand is exceeding supply), central banks tend to increase interest rates, which causes the cost of borrowing to increase, thereby restricting the amount of cash people have to spend in order to prevent inflation from rising too high. 

On the other hand, if inflation and growth are too low, then central banks tend to slash interest rates in order to promote borrowing and spending to kickstart the economy. Since the 2008 financial crisis, central banks around the world have pursued this policy in order to recover from recession. 

This means that interest rates around the world are really, really low at the moment. If we save money in a savings account, we might be making as little as 0.01% in interest each year. If inflation is at 2% a year, over time our savings will lose significant amounts of value. 

Investing

So, where does investing come into this equation? Well, investing is basically buying assets (such as shares, bonds, property or even classic cars) that may increase in price over time.  

The aim is to preserve the value of our savings, which, due to interest rates being lower than inflation (meaning our cash is being eroded quicker than it’s growing) will otherwise lose value. However, there is one key difference between saving and investing - risk. If money in a savings account loses value gradually, then it’s safe to say that investing can lead us to lose money rather quickly!

Investing is one of the key themes of the ICAEW Careers+ Personal Finance series, so stay tuned for more content about this topic.