Why Inflation Matters to Your Savings
When you save money, it is natural to focus on the balance in your account. If you have £10,000 saved today and still have £10,000 a year from now, the number of pounds has not changed. What may have changed, however, is how much those pounds can buy.
Inflation describes a general rise in prices over time. As prices increase, each pound has less purchasing power than it did before. If you would like to understand the underlying concept in more detail, What Is Inflation and How Does It Work? explains how inflation is measured and why changing prices matter.
Imagine that £10,000 today is enough to pay for a particular collection of goods and services. If the overall cost of those same things rises to £10,400 over the following year, keeping £10,000 unchanged would leave you £400 short of being able to buy the equivalent amount. You have not lost £400 from your account; instead, the purchasing power of the money has fallen.
This distinction between the amount of money you have and the amount that money can buy is central to understanding inflation. Why Inflation Reduces Your Purchasing Power explores that relationship in more detail.
For savings, there is another part of the equation: interest.
Money held in an interest-paying savings account can grow while prices are rising. Whether your savings are gaining or losing purchasing power therefore depends not simply on inflation, but on how quickly your savings grow compared with how quickly prices rise.
A savings balance tells you how many pounds you have. Looking at interest and inflation together provides a broader view of what may be happening to the purchasing power of those pounds.
Can Your Savings Grow While Losing Purchasing Power?
Yes. A savings account can earn interest and show a higher balance while the purchasing power of the money falls.
Suppose you place £10,000 into a savings account paying 3% interest. If the rate remained unchanged for one year, the balance would grow to approximately £10,300.
Looking only at the account balance, you have £300 more.
Now suppose prices rise by 5% over the same period. Something that cost £10,000 at the beginning of the year would, as a simplified illustration, cost approximately £10,500 a year later.
Your savings have grown, but they have not grown as quickly as prices.
This is the distinction between the nominal value and real value of savings. Nominal value is the amount of money shown in the account. Real value considers what that money can buy after allowing for inflation.
The relationship becomes clearer when savings interest is below, equal to or above inflation.
Each example starts with £10,000 and looks at the position after one year. The savings balance rises in every scenario, but its inflation-adjusted purchasing power can move in a different direction. Savings earn 2% while prices rise by 5%. The account contains £200 more, but prices have risen faster. In today’s-money terms, the savings have lost purchasing power. Savings earn 3% while prices rise by 3%. The savings and prices have increased at the same assumed rate, so purchasing power is broadly maintained against this measure of inflation. Savings earn 6% while prices rise by 3%. The savings have grown faster than prices, so their purchasing power has increased under these assumptions. A rising savings balance does not automatically mean your money is becoming more valuable in real terms. The important comparison is between how quickly your savings grow and how quickly prices rise. These are simplified one-year illustrations. Purchasing power is calculated by adjusting the ending savings balance for the assumed inflation rate. Savings rates and inflation can both change over time.What Happens When Savings Interest and Inflation Are Different?
Interest is below inflation
Interest matches inflation
Interest is above inflation
The first scenario is particularly important. The saver has earned interest and the account contains more pounds, yet its purchasing power has fallen because prices increased more quickly.
The middle scenario also needs to be interpreted carefully. A savings rate matching the headline inflation rate means the money is broadly keeping pace with that measure of inflation. It does not necessarily mean every cost faced by the saver has increased at exactly the same rate.
The central principle is that interest tells you how quickly your savings are growing in pounds, while inflation helps you understand what may be happening to the purchasing power of those pounds.
Why Time Makes the Difference Bigger
A relatively small difference between savings interest and inflation may not appear particularly significant over one year. If that difference continues, however, its effect can become much more noticeable.
Both savings growth and inflation can accumulate over time.
If £100 increases by 3%, it becomes £103. A further 3% increase applies to £103 rather than the original £100, producing £106.09. The same cumulative principle can apply to savings earning interest and to prices rising through inflation.
This means a small annual gap between the rate earned on savings and the rate at which prices increase can become a much larger difference over ten, twenty or thirty years.
The rates themselves are unlikely to remain constant for such long periods. Savings providers can change interest rates and inflation rises and falls. Fixed-rate examples are therefore useful for illustrating the relationship rather than predicting what will actually happen.
If you want to explore specifically how inflation can change the purchasing power of a future amount, Calfiny’s Inflation Calculator lets you test different amounts, inflation assumptions and timeframes.
How Interest Can Help Savings Keep Pace With Inflation
Interest provides growth that can help offset some or all of the effect of rising prices.
Where interest is added to the savings balance, future interest can then be earned on both the original money and interest already received. This is the effect of compound interest.
Inflation can also accumulate over time because each percentage increase occurs on the price level already reached.
Over longer periods, there are therefore two changing values to consider: the growth of the savings balance and the growth in prices.
The example demonstrates why looking at interest without considering inflation can give an incomplete picture of longer-term savings growth.
The savings balance has increased by approximately £4,802. But because prices have also risen, the increase in purchasing power is much smaller.
Money earning no interest has no corresponding growth to offset rising prices. Interest-paying savings, by contrast, can provide at least some counterweight to inflation. Whether that is sufficient depends on the rates involved.
Calfiny’s Compound Interest Calculator lets you explore how savings can grow when interest is added over time. If the mechanics of compounding are unfamiliar, What Is Compound Interest? explains why earning interest on previous interest can make growth accelerate.
For the purposes of inflation, the important point is that compound interest can work in favour of a saver while cumulative price increases work against the purchasing power of the savings.
Why Cash Loses Value Over Time looks more closely at what happens when money has no growth to offset rising prices.
Does Inflation Affect Everyone’s Savings in the Same Way?
The basic relationship between inflation and savings is the same: when prices rise, the purchasing power of money can fall.
However, the extent to which an individual experiences those price increases may differ from the headline inflation rate reported for the wider economy.
Measures of inflation are based on changes in the prices of a broad selection of goods and services. This provides a useful indication of how prices are changing overall, but households do not all spend their money in exactly the same way.
Imagine, for example, that energy and food prices are rising particularly quickly while some other prices remain relatively stable.
A household that spends a large proportion of its income on energy and food could experience a different change in everyday costs from a household with a very different spending pattern. The published inflation rate can be the same for both even though their individual experience of rising prices differs.
This is why it is useful to be careful with statements such as a savings account being able to “keep pace with inflation”.
If a savings account pays 4% while the headline inflation rate is also 4%, it is reasonable to say that the savings are broadly keeping pace with that measure of inflation. It does not mean every item the saver buys increased by exactly 4%, or that their individual purchasing power has been preserved perfectly.
Headline inflation is nevertheless useful because it provides a consistent benchmark for understanding how the general level of prices is changing.
How Is Inflation Calculated? explains how that benchmark is produced and why an inflation measure does not precisely represent every household’s individual cost of living.
How Inflation Can Change a Long-Term Savings Goal
A savings goal often begins with a specific amount.
You might decide that £30,000 represents the amount associated with a future expense. If the goal is several years away, however, the amount eventually required could be different because the price of what you are saving towards may change.
The timeframe matters. A goal only a year away has relatively little time for repeated price increases to accumulate, while inflation can have a much greater effect on a target that is twenty years into the future.
But general inflation should not be treated as a precise forecast of the future cost of a particular goal.
House prices, university costs, cars, travel and other expenses can move differently from the overall level of consumer prices. Inflation is therefore more useful for testing how sensitive a future savings target could be to rising costs than predicting exactly what something will cost.
This is why a long-term target expressed only in today’s pounds can provide an incomplete picture.
Savings Growth and Future Costs Are Different Calculations
When a savings goal is many years away, there are two related questions to consider.
How Could Your Savings Grow?
Interest, contributions and time can change the amount held in savings. Growth calculations explore what a savings balance could become under different assumptions about these factors.
How Could the Future Cost Change?
Inflation and changes in individual prices can affect how much money may eventually be required. Purchasing-power calculations help explore what a future amount could represent relative to today’s money.
A savings plan has two moving parts: the money being built and the future cost of what that money is intended to buy.
Calfiny’s Future Value Calculator can be used to explore how money could grow over time under different assumptions.
The Inflation Calculator approaches the question from the purchasing-power side by showing how different inflation assumptions can affect what an amount of money could be worth in today’s terms.
Neither calculation predicts future interest rates, inflation or the exact future cost of a particular goal. Their value is in helping you explore how changing assumptions can change the result.
The practical lesson is not that every savings target should continually be increased by the latest inflation figure. It is that the amount accumulated and the eventual cost of the goal are different variables, particularly when the timeframe is long.
Does Inflation Mean You Should Invest Instead?
A savings rate below inflation does not automatically mean money should be invested instead.
Inflation risk is only one type of financial risk.
Savings and investments have different characteristics. Money held in a savings account does not normally fluctuate in monetary value in the way investments can, and eligible deposits with UK-authorised banks, building societies and credit unions may benefit from deposit protection subject to the applicable rules and limits.
Investments have the potential to produce higher long-term growth, including returns that exceed inflation. But their value can also fall, returns are uncertain and there is no guarantee that an investment will keep pace with inflation or that an investor will receive back everything they put in.
Moving money from savings into investments therefore does not remove uncertainty. It changes the types of risk involved.
Time can matter too. Money that may be needed relatively soon has different characteristics from money intended for a goal many years away, particularly because investment values can fall at the point when the money is required.
It is therefore more useful to think of saving and investing as different financial tools rather than competing versions of the same thing.
Savings can provide accessibility and greater certainty about the amount of money available. Investments introduce uncertainty in return for the potential for greater long-term growth. Which characteristics are relevant depends on the purpose of the money, timeframe and risks involved.
Inflation helps explain one of the differences between saving and investing, but it does not determine what someone should do.
How Inflation Affects Investments continues the subject by explaining how rising prices interact with investment returns and purchasing power.
Conclusion
Inflation does not necessarily make the balance in a savings account fall. It changes what that balance can buy.
Interest can help counter this effect by increasing the number of pounds held in savings. If savings grow faster than prices, purchasing power can increase. If savings grow more slowly than prices, the account balance can rise while purchasing power falls.
The difference can become more significant over longer periods because both interest and price increases can accumulate over time.
Inflation is also an important consideration when thinking about future savings goals. The amount you are building and the future cost of what you intend to buy are related, but they are not the same thing.
Understanding that distinction makes it easier to look beyond the savings balance itself and consider what those savings may actually be able to buy.
