Beginner's Guide To: Inflation

Inflation rose unexpectedly to 2.9 per cent last month which was a kick in the teeth for savers, but do you understand why? This week we explain what inflation is and what impact it has on your savings.

What is inflation?

Inflation reflects price rises across the economy. The rate of inflation is updated monthly although it does not reflect the average change in prices over the month; instead it is a year-on-year change.

It would be impossible to measure the price of everything, so instead prices of a basket of goods and services that a typical household buys are tracked such as energy, petrol, computers, bread, cars etc. The two main measures are the Consumer Prices Index and the Retail Prices Index. CPI has been the preferred measure of inflation since 2003.

CPI or RPI – what is the difference?

CPI does not factor in most housing costs therefore expenses such as house prices, mortgage payments and council tax are not considered, however, rental payments are, therefore CPI is usually higher then RPI. For an indicator as to whether interest rates will rise, CPI is the one to watch.

If you are in receipt of benefits or a pension then you need to be keeping a close eye on RPI because any increases are still linked to this measure.

What does this mean for savers?

In order to earn a decent return on your investment, it must grow by at least the rate of inflation for it to be beneficial to you.

For example, when measured against CPI, a higher rate taxpayer needs to be earning at least 4.84 per cent on their savings to even match the rate of inflation, basic rate taxpayers will require a rate of 3.63 per cent. If your savings account is paying less than that you're effectively earning a negative return once tax and inflation is factored in (unless of course your money is invested in a cash ISA as interest is tax-free).