Inflation explained

From Times Online
November 3, 2008

Inflation explained

David Budworth

Savers need to take the threat of inflation very seriously because it can erode the value of deposits at startling speed. If the value of your savings does not keep pace with rising prices, its buying power will be depleted quickly - and you may not be aware of it until it is too late.

Here we explain why inflation matters and what you can do to combat it.

What is inflation?

Inflation is a general rise in prices across the economy. The inflation rate is a measure of the average change over a period, usually 12 months.

There are two main measures. The consumer prices index (CPI) was adopted as the Government's preferred measure in 2003 and is used by the Bank of England for the purpose of inflation targeting. The target is 2 per cent, but inflation is currently a lot higher. In September it hit 5.2 per cent, which means that prices overall are 5.2 per cent higher than in September last year.

The oldest measure of inflation, the retail prices index (RPI), dates back to before the First World War. In September the RPI stood at 5 per cent.

What is the difference between RPI and CPI, and which is more useful?

The CPI excludes most housing costs. Rents are included, but house prices, council tax and mortgage payments are not. This usually means that CPI inflation is lower than RPI inflation, although this is not always the case.

Everyone should keep an eye on the CPI for an indication of whether interest rates are likely to rise or fall.

For anyone in receipt of a pension or benefits, though, the RPI is the one to watch because increases remain linked to the RPI rather than the CPI. Inflation-linked products, such as index-linked gilts, are also linked to the RPI.

Remember, though, that both of these official measures are calculated on the basis of an average notional shopping basket, but an individual’s spending patterns can differ dramatically. The Office for National Statistics has an inflation calculator that enables you to enter your personal expenditure patterns to calculate an approximate personal rate of inflation (see websites below).

Why does this matter to my savings?

Savings must grow by at least the rate of inflation to maintain their value. If they rise in nominal terms but fail to beat inflation, their real value will fall in terms of purchasing power.

With the CPI at 5.2 per cent, higher-rate payers need to earn at least 8.63 per cent gross interest before they start to make a positive return. Basic-rate taxpayers require at least 6.5 per cent.

If your savings account does not match or beat this rate you are effectively losing money.

Here is a guide to the interest that basic and higher-rate taxpayers need to earn to match inflation

Inflation rate of 5%

Basic-rate taxpayers need 6.25%

Higher-rate taxpayers need 8.34%

Inflation rate of 4%

Basic-rate taxpayers need 5%

Higher-rate taxpayers need 6.25%

Inflation rate of 3%

Basic-rate taxpayers need 3.75%

Higher-rate taxpayers need 5%

Inflation rate of 2%

Basic-rate taxpayers need 2.5%

Higher-rate taxpayers need 3.34%

Inflation rate of 1%

Basic-rate taxpayers need 1.25%

Higher-rate taxpayers need 1.66%

Do any savings accounts provide protection against inflation?

Index-linked savings certificates from National Savings & Investments (NS&I), which are backed by the Government, are tax-free and guaranteed to keep pace with the RPI for a fixed term.

The return is made up of a set interest rate plus the RPI figure, fixed for three or five years. You can invest up to £15,000 per issue, so you could shelter £30,000 in both the three and five-year plans.

You have to tie up your money for the fixed term to receive the advertised rate.

Look out for inflation-beating savings accounts and Isas from banks and building societies, too.


http://www.timesonline.co.uk/tol/money/reader_guides/article5001065.ece


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