What Is Deflation and How Is It Affecting Your Savings?

In February 2015, the Office for National Statistics (ONS) announced that year-on-year inflation stood at 0.0%. Then in April, for the first time since 2009, the ONS posted inflation at -0.1%.

In other words, we were in a period of deflation. The UK spent the rest of the year hovering between -0.1% and 0.1%. But what is deflation? What determines the rate of inflation or deflation? And what are deflation’s effects on your savings?

What Is Deflation?

‘Deflation’ and ‘inflation’ are terms which refer to a currency’s value versus the price of goods and services. ‘Deflation’ is used if the value is negative. It is given as a percentage because it compares the price of an imaginary ‘shopping basket’ of goods and services at two different times: usually a given month versus the same month the previous year.

In calculating the rate of inflation, the ONS fill this imaginary shopping basket with commonly bought goods and services: petrol, food, a haircut, etc. and compare how much it would cost in June this year with June of last. The percentage difference is the rate of inflation.

The value can be called the Consumer Price Index (CPI) or the Retail Price Index (RPI) depending on what is included in the shopping basket. Usually, CPI is used, and excludes some key factors like house prices and tax. Inflation is currently low because oil prices have dropped, and the pound has strengthened making imports cheaper.

What Are Inflation and Deflation’s Effects?

The most obvious effect of high inflation is that money you saved ten years ago would not be able to buy you the same amount of goods and services today as it would have then. High inflation can therefore be very dangerous for savers and pensions relying on savings made decades ago.

So is deflation good? Not always. If deflation becomes entrenched, there can be serious economic consequences as consumers, assuming prices will fall in the near future, put off spending, which slows down the economy.

This in turn causes retailers to sell goods even cheaper to boost sales. But this then increases consumers’ desire to wait until prices drop even further. The current trend in inflation rates, hovering around 0%, sometimes dipping to 0.1% deflation, is not thought to be dangerous to the UK economy.

How Does Deflation Affect Pensions and Savings?

Not only does the rate of inflation determine how much bang you’ll get for your buck in terms of purchasing goods and services, it also influences the interest rates banks pay on savings and the interest rates charged on loans.

An Inflation rate that is very low or negative (i.e. deflationary) usually signifies a period of low interest rates. It is also usually concurrent with low interest rates on mortgage payments.

Finally, when it comes to the state pension, inflation plays a key role.

The current triple-lock policy on state pension prescribes an increase in the state pension every year. The increase is set according to either the CPI, average earnings or 2.5%. Out of these three values, pension payouts will increase in line with whichever is largest.

This means that in periods of deflation or inflation under 2.5%, the state pension will increase by either 2.5% annually, or in line with average earnings increase should that value be over 2.5%

For professional advice on how best to plan for your future during this period of very-low inflation, contact our Hertfordshire financial advisors today on 01992 500 261 or email us at enquiries@gpfm.co.uk.

The articles in this newsletter are for information only and must not be considered as financial advice. We always recommend that you seek independent financial advice before making any financial decisions.