Why cash is costly in times of high inflation

With inflation rocketing and interest rates still languishing near record lows, investors could pay a price for keeping too much money in cash.

Significant shifts in the economic landscape can be unsettling for investors and many will be concerned, understandably, about how rising inflation might affect their finances

It is not just the rate of inflation that can impact investors’ finances, however. The relationship between inflation and interest rates matters too. To illustrate, in 2007 the UK CPI was 4.29%, far higher than the Bank of England’s target. The base interest rate at the time, however, hovered between 5.25% and 5.75% throughout the year. This meant that the value of cash savings kept pace with inflation and remained stable.

Fast forward to today, and savers are being heavily penalised with the base rate languishing at 0.25%. If the CPI is running at 5.4%, for example, and a deposit account is paying interest in line with the base rate at 0.25%.

While we’re unlikely to see rates return any time soon to the heady heights of 5%+, increases are on the cards, with central bankers acutely aware of the need control inflation. The US Federal Reserve has hinted at four rate rises during 2022, with experts predicting the Bank of England will do the same. This means the gap between interest rates and inflation will begin to narrow. However, we can expect that gap to persist for some time yet. So, to mitigate the impact on finances, investors should review their investment strategy.

Some assets, such as equities, are better equipped than cash to perform in high inflation, low interest rate environments. This isn’t to say cash should be avoided. It is pivotal to any well-balanced and diversified investment portfolio, offering capital security to cover unexpected short-term needs.

However, cash may be less suitable to achieving long-term financial gains. As the Financial Conduct Authority noted last year, “consumers who have an appetite to invest long-term are failing to consider the opportunities from investing, missing out on potential financial gains.”

As the FCA notes, investors can take steps to protect their portfolios from inflation. While asset-backed investments, such as equities, are far from immune to its effects, and investors can expect a bumpy ride over the short term at least, they do offer the prospect of outpacing inflation, especially over long investment timeframes.

Given the recent volatility in markets, investors may be tempted to try and ‘buy the dip’, which means entering the market when prices are at their lowest. But timing markets is risky – they are almost impossible to predict. And by delaying, investors could be missing out on the potential upswing.

Hoarding too much cash can be harmful. It may look safe on the surface, but lagging inflation, particularly if occurring repeatedly over several years, can cause serious damage to portfolio performance, and ultimately consumers’ financial futures