Inflation is back to haunt unwary savers

Some things influence personal finance the world over. The effects will be different depending on the context but they are always important for an individual planning for the future.

Inflation is just such an issue of universal importance. It is important to private individuals because of its impact on personal wealth. It is an invisible force that nibbles away without seeming to be a problem, but over time its effects can be significant.

When Adam Smith wrote of inflation in 1776, the methods were different, but the essence was the same. In those days, the local ruler would use slightly less metal in a coin than was officially declared. Though the difference might only have been a few grains of metal, when multiplied by all the coins produced in a year, it added up to a substantial sum.

These days inflation is caused by the creation of new currency. The economists try to keep track of it by attempting to measure money supply. The ways of measuring money supply are argued over, but without being too technical, the M3 (or M4 in the UK) number represents broad money supply.

In recent years for the governments of most major countries, the official inflation figures have been low. But money supply has remained substantially higher and, as a general rule, inflation follows money supply.

Inflation also follows commodity prices. The goods and services we all have to buy to survive are influenced by the prices of underlying or component commodities. Recent commodity-price index figures from The Economist show that up to 27 March ‘all items’ are up substantially over the past year. The index is up by 23.1% in dollar terms, 9.6% in sterling terms and 11.4% in euro terms.

These increases are starting to show in the UK. Inflation has recently passed the politically significant 3% on one measure, the Consumer Price Index. The more realistic Retail Price Index has been edging higher all year and now stands at a worrisome 4.8%.

While this may not sound like an earth-shattering number, it is worth remembering that inflation figures are historical data - they report what has happened - so by their very nature are almost certainly higher now than when measured.

Savings held in a bank account will certainly suffer. The purchasing power of savings will be eroded at an increased rate. As the prices of goods rise, the number shown on a bank account statement will not keep pace.

For the person of substantial savings, this poses a problem. Although cash is essentially a risk-free investment, in times of rising inflation the outcome is guaranteed - it will lose relative value.

While it is possible to invest successfully in a high-inflation environment, it is not easy and few will have the required knowledge, energy or skills to prosper.

The traditional investment for times of inflation is that of ‘hard money’. In other words, real money as it has been used for centuries - gold and silver.

While this is almost certainly the right investment choice to make, it requires specialist knowledge and involves substantial risk to capital. These are active and volatile markets that play out the whims of geopolitics and global business. Investing in gold or silver is not for the faint-hearted.

If numbers on a bank statement lose purchasing power, so too do debts on a bank statement. Loans held against productive assets, rented property for example, will often become more profitable as the debt value remains relatively static while rents and property values rise, but even this is not guaranteed as rising inflation usually leads to increases in interest rates.

These rising interest rates will often hurt the profitability of both major and minor companies. As might be imagined, this is not good for corporate bond or equity markets and since this is where we are all investing via our pension funds, higher inflation may yet prove to be a menace to us all.

• Stuart Langridge is an independent financial adviser.

Some things influence personal finance the world over. The effects will be different depending on the context but they are always important for an individual planning for the future.