Back in May 2022, the Bank of England (BoE) warned against the embedding of “inflation psychology” into the UK economy.

During a speech to ACCA Cymru Wales, the Bank’s chief economist Hugh Pill acknowledged that the economy was in an “uncomfortable situation” that meant “difficult times for many people”. But he added that inflation psychology could result in a “self-sustaining, expectationally-driven momentum, which would maintain inflation at elevated levels”.

As well as causing a headache for the monetary policy committee, this would be bad news for consumers, who have already seen their disposable income cut as food and fuel prices rise.

So, what is inflation psychology, what effect could it have on the UK’s rising cost of living, and what does it mean for your finances?

Keep reading to find out.

Inflation is at a 40-year high with further rises forecast

The latest figures from the Office for National Statistics (ONS) confirm that the Consumer Price Index (CPI) for the 12 months to June stood at 9.4%.

This is well above the BoE’s 2% inflation target, as it has been each month since May 2021. And it is set to rise further.

BoE forecasts suggest that inflation could peak at 11% and not return to its 2% target until 2024.

Speaking to the Association of Chartered Certified Accountants (ACCA) in Cardiff, Pill confirmed high inflation had been caused by a reduction in overseas labour, partly caused by Brexit, as well as stalling globalisation, and the longer-term influence of the coronavirus pandemic.

The supply chain crisis, China’s economic growth slowdown, and the war in Ukraine have also added to pressures on the economy.

Inflation psychology could hamper the Bank’s efforts to control the cost of living

According to Investopedia, inflation psychology relates to the way consumers and investors unknowingly influence inflation.

In a climate of rising living costs, we expect that prices will continue to rise. Buying goods now – rather than in the future when the price will be higher – represents a saving.

This can, however, become a self-fulfilling prophecy. If inflation psychology encourages consumers to spend more, demand increases and adds to rising inflation, and thereby to inflation psychology too.

The BoE’s recent increases to the base rate are an attempt to control rising inflation.

Pill confirmed that the Bank’s remit to ensure economic stability, while maintaining a 2% inflation target sustainably, is risky in the current climate.

If high inflation becomes the norm, directly influencing wage and pricing behaviours, inflation will continue to rise.

On the other hand, the current cost of living crisis could significantly reduce spending – and so demand and prices – over the longer term, as people have less to spend. This could lead to too sharp a drop in inflation, even below the Bank’s 2% target.

Patience and effective budget management is the best way to combat rising inflation

If you are concerned about the effect of a rising cost of living on your long-term retirement plans, revisiting your finances could help to set your mind at ease.

Revisit your household budget

Checking in with your household budget could allow you to identify areas where cuts could be made. Freeing up more disposable income can help you to regain control when money is tight but remember not to sacrifice your pension savings or investments.

While many households are struggling in the present, looking after your future self remains vital. Any cuts you make to pension contributions, investments, or protection products could have serious long-term consequences.

Be sure to maintain your emergency fund too, but don’t keep too much in cash. High inflation effectively reduces the value of your savings in real terms.

Stay focused on your goals and ignore the noise

Along with rising inflation, global events are leading to stock market volatility. War in Ukraine, Covid-restrictions and economic sanctions in China, and a bear market on Wall Street, could all be making you anxious about your investments.

Remember that staying calm and focusing on your long-term goals is key.

Revisit your retirement plans

Your retirement plan is designed to ride out periods of short-term volatility, but if your pension age is approaching, revisiting your plans could be a good idea.

You might decide to inflation-proof your income or use other income streams to fund your retirement, delaying taking your pensions.

These are big decisions but expert financial advice ensures that you make the right one for you, and at the right time.

Get in touch

Our Chartered Financial Planners have decades of experience and expertise dealing with global markets and long-term financial plans. Speak to us now and you can feel confident and in control of your financial future, whatever is happening in the wider economy.

If you have any questions, get in touch and speak to us today.

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Levels, bases of and reliefs from taxation may be subject to change and their value depends on the individual circumstances of the investor.