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The hidden cost of inflation on your income and the truth about falling rates

The hidden cost of inflation

UK Inflation 2023

On 4 January, Prime Minister Rishi Sunak set out his five priorities for 2023. The government's top priority is halving inflation by the end of the year. Sunak pledged; “we will halve inflation this year to ease the cost of living and give people financial security”.

Inflation was at 10.7% in December 2022, so the government is aiming for 5.3% (It is using CPI). Many expected inflation to fall quickly anyway, however, inflation is stubbornly high in the UK and remained at 7.9% in June 2023.

Even if the target is reached, what does this really mean to you and the money in your pocket?

In this post, we will explore the effects of inflation on income over time and reveal how inflation silently erodes your purchasing power. We will also debunk the myth that falling inflation rates automatically mean more money in your pocket.

What is inflation?

Inflation is the steady rise in the prices of goods and services over time. It affects the purchasing power of money, wage growth, and overall economic stability. In the UK, inflation is measured using the Consumer Price Index (CPI) and the Retail Price Index (RPI).

CPI measures changes in the prices of a basket of goods and services typically purchased by households. The basket includes a wide range of items, such as food, clothing, housing, transportation, healthcare, education, and recreation. The Office for National Statistics (ONS) collects data on the prices of these items each month, and the CPI is calculated based on the weighted average of price changes within the basket. CPI is the measure used by Rishi Sunak in his pledge and is currently running at 7.9%.

UK CPI inflation

RPI was historically the main measure of inflation in the UK, but it has been largely superseded by the CPI as the official measure. The older RPI measure, in addition to the items covered by the CPI, also includes housing costs, such as mortgage interest payments and council tax, and is currently running at 10.7%.

The hidden cost of inflation on your income

Imagine a world where prices never stopped rising; that is the reality of inflation. It gradually chips away at the value of your money. With each passing year, the same amount of cash can buy less than it used to, leaving you feeling the squeeze on your purchasing power.

You work hard and expect your income to keep up with the rising cost of living, but the effect of inflation is mostly hidden. Sadly, wage growth does not always keep pace with inflation, as we are seeing in the current Public Sector pay dispute. If income is not rising as fast as prices, it is like trying to catch a runaway train with a slow-moving bicycle. Your real purchasing power takes a hit, even if you receive a raise.

For example, If your take-home pay in 2003 was £20k, simply keeping pace with CPI inflation, your take-home pay in 2023 would now have to be £35k. This gap is widened further if we take into account income tax and national insurance:

Inflation & income

The impact of a 6% pay rise in the face of 8% inflation

Picture this: you receive a long-awaited 6% pay rise, which sounds great, but inflation is running rampant at 8%. When inflation outpaces your pay rise, in real terms, your purchasing power actually diminishes. It's like running on a treadmill - working harder, but staying in the same place financially. The struggle to maintain your lifestyle becomes all too real.

As inflation rages at 8%, you find yourself trapped in a whirlwind of rising prices. The same groceries, fuel, and bills that used to fit within your budget now demand more of your hard-earned money. Despite the 6% pay rise, you are forced to tighten your belt, make tough choices, and prioritise your spending. Sacrifices become the norm as you struggle to stretch your income to cover your essential needs.

How inflation treats different income groups

Inflation is not an equal opportunity offender. It tends to favour those with deeper pockets or investments that thrive in inflationary times, leaving those with limited means in its financial wake. If you are fortunate enough to have higher disposable income (or discretionary spend) or assets that rise with inflation, like property or stocks, you may weather the storm more easily. But, for those on lower incomes or with fewer assets, it can be an uphill battle, as money struggles to keep pace with ever-increasing costs.

The truth about falling rates

The truth about inflation

Do not be fooled by the allure of falling inflation rates. They might seem like a glimmer of hope; things will get better if rates fall….but, the reality is different from what meets the eye. Here is the truth:

A slowdown in inflation does not mean prices drop.

When inflation rates fall, it simply means prices are rising at a slower pace.

It is like tapping the brakes on a car, but you are still moving forward. So, while it might feel like a breather from the relentless surge in prices, you are not out of the woods yet. Do not expect a magical dip in prices just because the inflation rate number has fallen.

Falling inflation rates are merely a temporary respite. The long-term effects of inflation on your income remain. Prices will continue to rise, eating away at your purchasing power over time.

The reality of falling inflation

Let's say that in the previous year, the annual inflation rate was 10.7%. This means that, on average, prices across the economy increased by 10.7% over that year. However, in the current year, the annual inflation rate falls to 5.3%. This decrease in the rate of inflation means that prices are still rising but at a slower pace compared to the previous year.

If a weekly basket of goods and services cost £100 at the beginning of the previous year, with a 10.7% inflation rate, the same basket would cost £110.70 at the end of the year. However, with a 5.3% inflation rate in the current year, the same basket would now cost £116.57.

Without a pay rise, after 2 years you now need to find an additional £16.57 every week for the same basket of goods. Say you were given a 6% pay rise; you would still be short by £10.57 every week. This is also assuming you are not taxed on the pay rise, which opens a whole new can of worms!

What can you do?

Inflation is a silent thief, gnawing away at your income and purchasing power. It is essential to understand its impact and take proactive measures to protect your financial well-being. Do not fall for the allure of falling inflation rates.

Explore opportunities to supplement your income: This could involve taking on a part-time job, freelancing, or monetising your skills. Every additional penny earned helps in combating the impact of rising prices. If you cannot increase your income, then you need to redraft your financial plan; adjust your budget, and spend intentionally.

Prioritise financial goals: In challenging times, it's crucial to focus on your financial goals. Review your priorities and make adjustments accordingly. Re-evaluate your short-term and long-term plans, ensuring they align with your new income and spending reality.

Lifestyle adjustments: The storm of high inflation forces you to reassess your lifestyle and make difficult adjustments. Luxuries you once enjoyed may need to take a backseat as you focus on meeting essential expenses. Vacations, dining out, and other discretionary spending become less frequent or disappear altogether. Your ability to save for the future or achieve long-term financial goals may also need to be reassessed for the short term.

Track and trim expenses: adopt a vigilant approach to your expenses. Track every pound spent and identify areas where you can cut back without sacrificing necessities. Look for deals, discounts, and ways to save on everyday purchases. By becoming a savvy shopper, you can mitigate some of the effects of high inflation.

Embracing a more frugal lifestyle can help you weather the storm of high inflation. Make conscious choices to reduce waste, find cheaper alternatives, and repurpose items. Consider DIY projects and find joy in simpler pleasures that don't strain your wallet.

Inflation significantly influences income and financial well-being over time. It erodes the purchasing power of money, impacts wage growth, and affects different income groups in different ways. Falling inflation rates do not automatically guarantee improved financial situations. It is important to recognise the challenges inflation poses, and by proactively managing your finances, seeking ways to increase income, trimming expenses, and prioritising your goals, you can mitigate its impact and safeguard your financial stability.


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