There’s a good chance you’ve seen headlines recently highlighting concerns over rising inflation. In fact, Standard Life reports that the UK saw seven consecutive months of double-digit price rises to March 2023.
To combat this rising inflation, the Bank of England (BoE) has been steadily increasing its base rate. This is the central rate that essentially influences interest rates on savings and borrowing across the economy.
While this may result in banks and building societies increasing interest rates on savings accounts, you may want to consider the effect of inflation on your wealth and think twice before moving more of your money into savings.
This is because inflation is still higher than the rates many banks offer, which could mean that rising prices erode your wealth’s purchasing power over time.
Continue reading to discover how high inflation can affect your cash savings and why you may want to consider investing instead.
Inflation can erode the real-term value of your cash savings
As mentioned, the BoE has been increasing the base rate in recent months, rising to 5% at the latest review on 22 June. The UK’s central bank does this to encourage saving and deter borrowing and spending during periods of high inflation.
Despite this, some experts predict the Bank could raise the base rate even further, potentially peaking at 6.5% at the end of 2023.
This is because inflation is still high. Indeed, the Office for National Statistics reports that the Consumer Prices Index (CPI) rose by 7.9% in the 12 months leading to June 2023. This means that, on average, goods and services that cost £100 a year ago now cost £107.90 today.
Meanwhile, Moneyfacts states that the best rate for an easy access savings account is 4.55% as of 19 July 2023. For reference, This is Money states that the average easy access savings account rate rested at an all-time low of 0.18% in early 2021.
Even though average interest rates offered now are much higher than they were in 2021, they’re still lower than the rate of inflation. In theory, this means your savings’ value erodes in real terms and you can buy less with your cash today than you could a year ago.
Research from Standard Life gives a further example of the effect inflation can have on your cash savings. If you had £10,000 in savings earning 3% in interest, its purchasing power would drop to £8,593 after a two-year period of 10% inflation.
So, you can see how inflation might reduce the value of your money in real terms, even if you’re receiving a higher interest rate on your savings than you were previously.
By investing, your wealth could keep pace with inflation
As you can see, it’s challenging to find a savings account that pays interest high enough for your savings to keep pace with inflation. Fortunately, you may be able to prevent the erosion of your wealth’s purchasing power by investing, as you could potentially benefit from higher returns by doing so.
Indeed, IG reveals that the FTSE 100 stock market index has historically generated average annualised total returns of 7.48% since its inception in 1984.
Even though this isn’t quite as high as the current 7.9% inflation rate, it is better than the interest rates offered by most savings accounts. In turn, this may give your wealth more of a chance to keep pace with inflation.
For reference, HL’s inflation calculator shows that, based on the Retail Prices Index (RPI), £10,000 in February 1984 would be worth £43,578 today. Your wealth would need to have grown by an average of 3.8% each year to keep pace with inflation over this period.
That means the average annualised returns offered by the FTSE 100 would have kept your wealth ahead of inflation during this period.
Of course, not every year is the same, and markets may sometimes experience a significant downturn. However, it’s important to take a long-term view when you’re investing.
To show the importance of a long-term stance when you invest, look at the below chart showing the performance of the FTSE 100 between 1984 and 2023:
Source: London Stock Exchange
As you can see, several significant downturns have occurred in the past, such as the 2008 financial crisis and the Covid-19 pandemic.
While these events did reduce the value of the index, there has been a general upward trend over time. By adopting a long-term investing strategy, you can give your assets more time to grow, and maybe even a chance to recover from any periods of short-term downturn.
It may still be worth retaining some of your savings as cash
Even though your wealth could potentially be better off invested to stay ahead of inflation, you may still want to hold some of it aside as cash.
It may be prudent to build an emergency fund to ensure you have enough disposable cash to cover any financial difficulties. For instance, if your car broke down and you rely on it for work, would you have enough money to cover the costs?
You may want to keep as much as three to six months’ worth of essential household expenses in an easy access savings account. If you have many dependants or are self-employed, you may want to consider holding as much as 12 months’ worth of expenditure.
Keeping a “rainy day” fund means you’ll have cash to rely on in the event of a sudden loss of income, or if you’re faced with an unforeseen expense.
On a similar note, if you plan to retire in the next few years, it may be worth holding some cash aside to protect you in the event of short-term market volatility.
Get in touch
If you’re struggling to decide how much cash you should realistically hold as savings and how much you should invest, we can examine your circumstances and help you figure it out.
Email info@blueskyifas.co.uk or call us on 01189 876655 to find out more.
Please note
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.