Rising prices: the greatest threat to your finances

Neil Faulkner looks in depth at what the ominous surge in inflation means for you and offers his tips on how to avoid the worst possible ramifications.

Figures out this week show the largest ever increase in the inflation rate between two months: November and December 2009. This increase is a warning for borrowers and savers alike, as it can affect our interest rates. I'll get to that later. First, though, the figures...

The Consumer Prices Index, the measure of inflation used by the Bank of England, went up one percentage point in December from 1.9% to 2.9%. Although the huge jump significantly overshot most forecasters' estimates, the Bank said months ago that a big spike would happen in early 2010 and that we basically shouldn't worry about it. Here's the thinking behind it:

Take yourself back to December 2008

There were a number of exceptional events that took place a year ago which sharply lowered the annual inflation rate. These were:

• The reduction in VAT from 17.5% to 15%.
• A huge fall in the price of oil.
• Early Christmas sales to try and get customers into stores during the recession.

One year later, those lower figures make today's inflation rate look much stronger. However, the Office of National Statistics says that perhaps just 0.4 percentage points were a result of this balancing act, which means there is still 0.6 points of inflation that is not caused by exceptional items. Whilst forecasters expected a jump, the size of it is larger than most estimated.

Let's think bigger

I don't want to put overdue importance on one month's figures, so let's broaden it to the past three months. Annual inflation has gone from 1.1% in September to 2.9% in December. It's almost tripled in three months, accelerating each month even when you exclude the exceptional items from 2008. This quarterly figure is perhaps a better indication of the swift turnaround in inflation that we've been experiencing.

All the signs are there for higher inflation: we shopped more over Christmas suggesting we're gaining confidence to spend, banks are lending more money (and more money being borrowed and spent means more businesses putting up prices, i.e. inflation). On top of that, we have this:

• A weak pound: means more expensive imports.
• Rising commodity and energy prices: Asian economies are hungering for more resources, which will push up our own costs regardless of what we do to fight inflation domestically.
• An injection of new money (quantitative easing): which has been perhaps ten times larger than it was in the 70s, just before we had our last period of extremely high inflation.
• Low interest for a long period already: which could eventually start stoking our desire to borrow more and save less.

Taken together, we have the greatest chance of high inflation than at any other time for decades.

But high inflation is not a certainty

Let me be clear about that: 'the highest probability' is not a certainty. Far from it. However, now is as good a time as any to err on the cautious side and take safety measures. We must take inflation seriously as it's the biggest possible threat to our finances over the next few years. Inflation would be fought with unfavourable interest rates which could cripple our finances or destroy our savings.

Here's some guidance for mortgage holders and savers:

Mortgage borrowers and inflation

Provided you've been making a war chest of savings, or overpaying your mortgage, taking out a fixed-rate mortgage might not be necessary, yet it's worth considering the effect on your mortgage costs if the Bank of England base rate was to rise rapidly to 5% to fight inflation. If that happens, many of you will be paying more than 7% APR on your trackers and possibly 9% on your standard variable rates.

I wrote a year ago that the best alternative to overpaying on a variable rate were very long-term fixed deals. They need to be long, as we don't know when rates will rise.

Almost 12 months later, ten-year fixed deals are still around the same price of 5.5% to 6% APR with reasonable fees, plus we have the benefit of greater choice. Last February I could find just one quality fixed deal with Britannia. Now a quick scan shows the Co-op Bank, and Yorkshire and Principality building societies, have joined it. I'm sure our mortgage service can uncover plenty more long-term deals for you.

Use lovemoney.com's innovative new mortgage tool to find the best mortgage for you online or read the top mortgages for 2010 to get the lowdown on the best deals available at the moment.

Savers and inflation

It's easy for savers to overlook the cost of leaving their savings in an account where they're not earning much interest. It may be that you just want somewhere safe to stash your cash, but a savings account that isn't matching inflation - after tax - is not safe. As time goes by, you can buy less and do less with that money.

For example, if you earn 2.5% interest after tax when inflation has risen to 4% then, after five years, £1,000 of savings will be worth just £930 in today's money, even though you're account will show a 'gain' of more than £100. The greater the difference between inflation and your savings rate, the bigger your losses in real terms.

I find savings decisions easier compared to mortgages, because I consider the purpose of savings accounts (for most people) to be simply about protecting our savings from inflation.

If your goal, like mine, is to ensure you keep beating inflation then you should keep your money in an easy-access account (and the tax-free equivalent the cash ISA) or lock it up in a National Savings & Investments' savings certificate. Easy access savings accounts typically beat inflation and sometimes give a profit too, as well as keeping your money accessible, so you can move your money around chasing the best rates. NS&I savings certificates often don't pay as well and aren't as flexible but are guaranteed to beat inflation, and offer a tax-free return - even if you've used up your Cash ISA allowance. What more do you need?

Read the top 10 cash ISAs for 2010 and The top six places to invest your money in 2010 for details of the best places to put your stash of cash.

Inflation-beating lovemoney.com resources

Now, and before fixed rates rise, is a good time to take a look at the mortgage deals on the market, so compare mortgages with our award-winning service. It may be that savings account deals will rise in the coming months, so keep your money flexible.

And remember, lovemoney.com can help you with all your financial goals, whether it's Cutting your mortgage costs or Saving money every day.

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