How inflation is hitting us all in our pockets

IT'S been a week of surprises with inflation climbing ahead of expectations, more people out of work and the economic recovery roaring ahead not so much like a lion as a mouse. The consumer prices index (CPI) shot up to 3.4 per cent, well above its 2 per cent target, while the retail prices index (RPI), which includes housing costs, soared even higher to 4.4 per cent.

Economic activity hardly recovered at all against this background of rising prices, crawling ahead by an anaemic 0.2 per cent against an anticipated 0.4 per cent between January and March – with the bad weather at the year's start taking the blame.

Unsurprisingly, the numbers out of work across the UK rose by 43,000 to 2.5 million, and in Scotland alone by 6,000 to 208,000.

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Rising prices hit all age groups by eroding wages and savings. So is stagflation, that is rising prices and low growth, here to stay? And if so, how should consumers best cope?

Governor of the Bank of England, Mervyn King, always predicted that inflation would shoot up temporarily at the beginning of the year before settling again. But inflation is the genie which, once out of the bottle, can be impossible to control. There are fears that the weakness of the pound will import inflation.

Your pay packet

How you cope financially will depend on where you work. According to the latest statistics from the Office for National Statistics, public sector pay is keeping pace with CPI, if lagging RPI slightly.

Public sector pay increased 3.9 per cent to 23,868 in February, compared with a year ago. Those working in private industry have not fared so well. They have experienced a sharp pay cut in real terms, with annual pay rises of 0.9 per cent, falling well below the increase in prices as measured both by the CPI and RPI indices. Private sector pay is now 21,736 on average, with rising inflation triggering a fall in living standards.

Your savings

Inflation can rapidly erode the value of your savings, so to maintain your buying power, a basic rate taxpayer has to earn 4.25 per cent annually, while a higher rate taxpayer must earn 5.64 per cent just to break even.

This is almost impossible to find. The best accounts come with all kinds of restrictions and are not open to everyone. For example, HSBC is paying 8 per cent on a regular saver, but this falls to 4.42 per cent when averaged across the year. Furthermore it is only available to customers paying for one of the bank's packaged accounts.

Santander will pay 6 per cent on a regular saver, but you can roughly halve this for the annual return.

Yorkshire Building Society will pay 6 per cent on 5,000 provided you subsequently invest the cash in a hybrid equity account run by Legal & General, which will not appeal to many.

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It is particularly important at this time to search out tax-free accounts to make sure the taxman doesn't help himself to the small amount of income you are able to earn.

This means Isas, but here too the returns are underwhelming, with Santander paying 3.2 per cent, of which 2.7 per cent is a bonus which ceases after the first year. Nationwide's e-Isa is paying 2.75 per cent.

National Savings is the other place to look for tax havens, and its index-linked certificates appeal for offering both a hedge against inflation and a tax shelter. Index-linked savings certificates are currently paying 1 per cent on top of the retail prices index over either five or three years.

Savings institutions are exceptionally quiet at the moment, watching the electioneering with interest. Clydesdale Bank was one of the few to launch a new account last week with its three-year bond paying 3.9 per cent.

Institutions are waiting to see who wins the election, and whether the result triggers a rise in interest rates. Though unwelcome across the economy as a whole, higher interest rates would be celebrated by savers.

Your pension

Pensioners suffer on three fronts. Their state pensions are increased annually in line with the September figure for RPI. If King is right, and high inflation early in the year falls back in the second half, then next April's increase may not reflect the sharp rise in prices during the first half of 2010.

Those with company pensions may also suffer, unless their retirement income is directly linked to the RPI. Few employees in the private industry enjoy such a perk, although it is relatively common for state employees.

Private sector pensioners may receive no up-rating. More likely, though, they will benefit from a capped RPI uplift. In other words their pension will be increased by the rise in the RPI, but only up to, say, 2.5 or 3 per cent. This means their pension is falling in real terms.

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Finally, pensioners' living standards are being hit hard by the low returns on their savings.

Students

Students and graduates with student loans could see a sharp increase in their repayments.

The Student Loans Company sets interest in September, but it is based on the March RPI figure, which this year hit 4.4 per cent.

Many students have this year enjoyed charges of zero interest after RPI went into negative territory last year.

Scholars who took out student loans prior to 1998 have slightly different terms which allow their interest to closely match RPI.

They are currently enjoying minus 0.4 per cent interest following last year's inflation dip, so a hike to 4.4 per cent is likely to prove even more painful.