Inflation rates are set to fall, but the past damage remains.
What is happening to inflation?
Annual inflation reached 5.6% last September, as measured by the retail prices index (RPI). That was its highest level since June 1991. Inflation has since started to drift back, with RPI down to 4.8% in December 2011, and the general expectation is that the fall will continue well into this year.
The Chancellor’s financial watchdog, the Office for Budgetary Responsibility (OBR), calculates that annual RPI inflation will be 3.3% by the end of 2012 and 2.9% in the following year. The Bank of England is similarly optimistic that inflation will drop, although the Bank’s inflation forecasting record in recent years has been far from perfect.
Three letters sum up one of the main reasons why there is a widespread consensus that inflation will fall: VAT. In January 2011, the standard rate of VAT increased from 17.5% to 20%, but there was no such increase at the start of this year. Thus 2012 has started without tax-driven price increases, so inflation should be lower.
Whether or not the economists are right about the future path of inflation, there is no doubting about its past. Over the last two years (to December 2011), the RPI has risen by just under 10%. In other words, £1 in December 2009 has the buying power of 91p today.
Such a level of price increases means that you should consider reviewing your financial plans now, if you have not done so in the last 12 months. For example, your life cover should normally be adjusted in line with inflation or its real value will fall. In round numbers £100,000 cover in place two years ago needs to be £110,000 today, just to retain the same purchasing power.
There are similar considerations for your income protection cover. If £30,000 a year was adequate cover for you at Christmas 2009, then today your cover should be £33,000. Regular savings feel the draft from inflation, too. For example, if you started setting aside £250 a month at the start of 2007, to maintain the real value of that investment, you should now be saving at the rate of £295 a month.
Inflation will also mean that your retirement planning could need a reassessment. The erosion of value caused by recent inflation will still be there when you retire, unless you make appropriate adjustments. That could mean higher contributions, a later retirement date or a combination of the two.