How much do you think a gallon of milk cost 100 years ago? What about bread, flour, and butter? Would you believe it if I told you it was a fraction of a penny for a loaf of bread and a few pennies for a gallon of milk? This substantial increase in the prices of goods over time is, as you might’ve guessed, inflation.
Inflation is a fact of life, even with little to no increase in money supply (which is not the case for most economies), increasing demand due to an increasing population coupled with slower growth in the supply of goods due to the scarcity of resources will always lead to inflation, among other reasons. It is critical to understand this phenomenon, which we will try to explain in this article.
Current Inflation vs Inflation Targets
Central banks have inflation targets because some inflation is a sign of a healthy economy; it shows that the economy is growing, people are making money and spending money. But here is the catch, it is your money that is losing value. Yes, you are losing money by keeping your money as cash in the bank.
If inflation averages 2.5% per year for the UK, that means that your £100 will be worth £97.5 in a year from now, and it keeps discounting from that point onwards. In 30 years, prices of milk, bread, flour, and eggs will double, assuming 2.5% inflation per year only. So, in 30 years’ time, your cash is worth one-half what it is now. The worst thing is there are no guarantees that inflation will remain low for 30 years. In fact, inflation in 2023 is over 6% (see here for latest inflation figures in the UK). This means the value of your money will halve even sooner.
Personal Inflation
Ultimately, I think that published inflation metrics, such as the Retail Price Index (RPI) in the UK, are somewhat inaccurate. RPI tracks the prices of a basket of goods and services that not everyone is necessarily buying (e.g. alcohol). This means that inflation may and probably will affect different people differently. That is why I think personal inflation is an important concept. It is meant to be informative yet simple. It starts with noticing the unusual price hikes in daily or monthly outgoings. This becomes hard to miss with an up to date budget (learn about our zero-sum budget strategy here) and/or a digital bank account with analytics.
For example, I know that I am paying 30% more for my petrol, 20% more for my morning coffee, and 8% more on my energy bills this year. This will inform lifestyle changes that will ultimately save me money, such as driving my hybrid on eco (and going electric for my next car!), investing in a coffee machine and a thermal cup, and keeping an eye out on light switches and thermostat.
In conclusion, it is very useful to keep track of meaningful price hikes in your monthly outgoings. By noting these price increases, you can save money and soften the blow to your finances due to inflation. Bear in mind that this is not enough to beat inflation, for that, one must invest in the markets (Learn more about investing here), but even then, inflation comes with a price, the diminished real return.
Real Returns vs Nominal Returns
You might be thinking “but I have my cash sitting in a high yield savings account”. Well, your savings account is still losing you money, the interest is almost always lower than inflation. Now is the time for the most important takeaway lesson of today, real vs nominal returns.
Real returns are the returns you make on your investment after inflation; while the nominal return is the return you make before accounting for inflation. It is quite simple to calculate, you subtract RPI (or CPI in the US) from the return on your investments (not quite, but this approach is good enough). Now you can see that with today’s interest rates and reported inflation figures, you are making negative returns! Yes, you are losing money to inflation by keeping cash in savings.
Time Value of Money (TVM)
The fact that purchasing power decreases over time and that your cash is worth less in the future leads to the important concept of time value of money (TVM). In essence, TVM states that one dollar today is worth more than one dollar tomorrow. Originally, TVM had to do with the opportunity cost of delaying cash flow; if you can make a return on your money in the bank, why would you wait to get paid? TVM then leads to the concepts of present, future, and net present values, all of which are discussed here. But for the purposes of hedging against inflation, you just need to know that your money is worth more now than later because of inflation and opportunity cost; this could help us at fighting inflation.
The Remedies
1. Keep a Budget
The first thing to do is to have a budget. Inflation hits houses with lower income harder than those with more disposable income. That is why it is imperative to keep an accurate budget and track spending. If you don’t have a budget, we have a great guide on this budgeting technique that might be useful here.
2. Use your TVM
You now know that your current savings are worth more than your future earnings/savings, so why would you make a purchase now if you can finance it using future earnings? Now don’t get me wrong, I am not talking about making purchases using high-interest credit cards, what I mean is making use of interest-free finance. Find out if a necessary big purchase can be financed interest-free, or look for limited time 0% interest offers on credit and balance transfer cards. This would allow you to keep your savings invested while financing your needs with future (cheaper) earnings!
3. Check Your Mortgage
High inflation is usually met with increasing interest rates. This means that if you have a variable or floating mortgage rate, you are exposed to these increases. This is very important because small increases in the interest rate lead to a large increase in your outstanding balance. So make sure you fix your mortgage rate at a low-interest rate. Maybe even consider remortgaging your house while you are at it to capitalize on the housing market rally of 2021!
4. Pay off (or move) Bad Debt
Bad debt is any debt with high interest. Think about your credit card debt, growing at double-digit interest. Again, when central banks increase interest rates, your credit card provider will increase what is an already high-interest rate. So shop around for a 0% balance transfer card offer to park that debt there while you pay it off using future earnings. If you can’t, pay it off using your savings; this is sensible because the interest rate is so high, your real return on your savings is probably much lower and it makes financial sense to pay it off. Should you not have savings to cover your debt, you may find that taking out a personal loan to pay off these debts is better, personal loans could carry much lower interest rates.
5. Pay Less For Stuff
Yes, high inflation means higher prices, but that doesn’t mean you have to pay the price tag every time! Vouchers are your best friend. Use Honey chrome extension to apply discount vouchers automatically at checkout. Use Groupon for vouchers on everything leisurely from afternoon tea to spa days.
6. Get Cashback
Double down your savings with cashback. Why not combine your discounted deal with cashback from Quidco, Top Cashback, or Airtime Rewards? Check out our article on cashback and how to make the most of it.
7. Invest, Invest and Invest
To beat inflation you need to make returns in excess of inflation, and no, tucking money away in high yield savings accounts or safe government and corporate bonds is not enough. You need to make better investment decisions, and here at hack your wallet, we know it is tough to navigate that scene at first. That is why we introduce every asset class you need to know about here.
In Summary,
Inflation is a fact of life and it eats your cash year after year. The worst thing is, it hits homes with lower incomes the hardest. But there are things you can do to soften the blow. Start with a budget, use your purchasing power now and manage debt. Develop a habit of using vouchers and cashback sites and invest your savings religiously. Combined, these financial habits will help beat inflation and make the most out of your money.
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