How inflation and interest rates impact on your savings

Inflation is the increase in price of a country’s goods and services.

In the UK, the rate of inflation is commonly measured by the consumer price index, or CPI, or the retail price index, or RPI.

Both calculate the current rate of inflation by analysing the cost of hundreds of items, from consumer products such as bread, alcohol or cinema tickets, to mortgage rates and council tax.

Various factors affect the rate of inflation, from the fluctuating value of the pound to wage increases, but inflation impacts us because it reduces the spending power of our money over time.

Ten pounds today is worth less than ten pounds a decade ago because we can buy less with it.

At times when the value of the pound is weaker, inflation rises because the cost of goods and raw materials become expensive.

As businesses bear the brunt of these increases, they pass on the burden to consumers, creating a surge in living costs, and a squeeze on personal finances.

Central banks, such as the Bank of England, use financial levers to help control inflation and stabilise its effects on the economy.

One of these is interest rates.

By increasing the rate of interest, central banks encourage consumers to save their money, not spend it. This creates a cooling effect in the economy, ensuring inflation never spirals out of control.

But as interest rates rise, so debt-holders’ repayments increase. Mortgage holders in particular will feel the impact, as the amount they pay back each month grows, leaving them with less disposable income.

For investors, a rise in interest rates and inflation can lead to varying outcomes.

For example, bonds are generally less attractive, because the increase affects the fixed rate of income paid out.

If inflation rises, shares tend to perform well, because as businesses can raise their prices, their share value will grow in turn.