Inflation hit 3.3% in May, well beyond its official target. And the Bank of England warns it could hit 4% before 2008 is over. But, as Hannah Ricci reveals, there is a way to recession-proof your finances.

Chances are you’ve noticed prices creeping up in most areas of your life lately, from your weekly grocery shop and council tax, to travel costs and fuel bills. Despite wages rising by an average £44 a month this year, families are facing an increase of £148 a month in essential living costs, according to a survey by uSwitch.com.

It found that the average pay rise in Britain would be 3.4% this year, compared with a 9% rise in bills, meaning the nation’s households will be left £21 billion out of pocket.

Inflation has been on the rise in the first months of 2008, hitting 3% in April and 3.3% in May. But for many people across the UK the rate of inflation actually feels much higher, as price rises start to bite.

The top five energy companys have all put up their prices, water bills are set to rise by 5.8%, and council tax is likely to increase by 4%.

Food prices are also on the rise, with food price inflation at its highest since June 2001.

Analysts at mySupermarket.co.uk, which tracks food prices, say the three biggest supermarkets - Tesco, Asda and Sainsbury's - increased their average price for a basket of goods by 21% over the past year.

The cost of getting from A to B has also increased beyond inflation. Rail fares have risen by an average 4.8% this year, with some commuters facing hikes of 14.5%. The price of fuel has also rocketed.

So, for many people the government’s ‘official’ rate of inflation is meaningless. Just how much inflation hits you will depend on a number of factors such as your age and circumstances and the way you spend your money.

“We really should ignore the ‘official’ inflation rate,” says Francis Klonowski, director of financial planners, Klonowski and Co in Leeds. “Because most of the things that we can’t run away from are going up by more than the rate of inflation, such as council tax and gas and electricity.”

An independent study from Alliance Trust that looks at how inflation affects different groups of people, found that in January all age groups faced an inflation rate higher than the official figure.

The general rule is that the less wealthy suffer the most, because they don’t have surplus income to absorb rising costs. Retirees are the hardest hit of all because most pensioners’ incomes are fixed and a large proportion of it is spent on necessities such as utilities and food – which are rising the fastest. According to the study, those aged between 50 and 74 have the biggest average inflation rate of 2.9% - 32% above the official rate.

“Millions of pensioners are again facing inflation-busting bills for vital household services,” said David Sinclair, head of policy for Help the Aged. “One in five older people survive below the poverty line - when all the spiraling household bills are paid they are left with less and less each year to afford basics like food and clothes.”

However, wealthier middle-classes aren’t immune. Areas where they spend money, such as school fees, childcare and private healthcare are all rising well above inflation too.

The cost of independent education, which includes university fees, school fees and private tuition have soared by 13.2% in the past year, and are a third higher than they were three years ago. The average independent school now charges almost £9,000 a year for day pupils, while boarding fees have risen to around £20,000.

And according to the Daycare Trust UK, the cost of a typical nursery place for a child under two in England is now £8,368, a 5% rise since 2007. Households in the UK are spending almost £1,200 a year on private healthcare, according to research by think tank, Reform, and premiums for private health insurance soar by up to 15% a year.

Not everything is on the rise however. According to ONS figures, the price of clothing and footwear, furniture and audio-visual products have fallen this year - but this is little comfort to people who cannot afford these extras due to rising essential costs elsewhere.

Beat inflation

The first step to dealing with rising prices is to find out which areas of your expenditure are most vulnerable. Use the personal inflation calculator on the Office for National Statistics website to work out your own inflation rate. By entering how much you spend in different areas, it shows how your income is allocated and therefore what price rises will affect you.

Most of us could cut unnecessary costs by giving our household expenses a serious MOT. When prices are rising it’s more important than ever to ensure you’re not paying more than you need to for everything from your mortgage and utilities, to insurance and your weekly shop. This doesn’t have to mean cutting back or going without, just identifying areas where you can make savings that help to mitigate the effects of inflation on your finances.

Mortgage repayments are most people’s biggest expense, which is why Katie Tucker, technical manager at broker John Charcol thinks homeowners have experienced the highest inflation of all groups of people in the past year. “Whilst food price hikes affect everyone, and utility costs affect everyone running a home, mortgages have increased in cost considerably whereas rent has not so the mortgaged population's budget is squeezed more than anyone else's.”

Being on a dud mortgage deal or languishing on your lenders standard variable rate can cause an unnecessary drain on your finances, so take time to research the market and remortgage when your current deal comes to an end. “Anyone remortgaging from an SVR of 7.25%, to a rate of 5.05% or below, would effectively be offsetting the effects of inflation,” explains Tucker. On a £150,000 mortgage, switching between these rates would save £203 a month.

Shopping around is equally important when your insurance comes up for renewal. It’s the easy option to renew with your existing insurer, but the best insurance deals are usually offered to new customers, so it pays to see what else is on offer because the insurance market is very competitive.

Pretty much every household in the country will be experiencing an increase in energy prices, as the five big suppliers have all hiked their prices this year. Trying to save money here is a huge frustration because many people switched suppliers when prices dropped at the start of 2007, only for them to rise again a year later.

However while the savings for regular ‘switchers’ may be small, if you haven’t switched before you could save hundreds of pounds every year.

With other household services, such as phone, broadband and satellite TV, it’s just a case of shopping around to get the best deal and not paying for services you don’t need.

When it comes to shopping, Klonowski says it can be quite difficult to cut costs unless you are prepared to change your spending habits. But if you are, simple changes like switching supermarkets and sticking with supermarket branded products can make big savings. If you don’t have time to shop around yourself, Mysupermarket.co.uk compares prices across Tesco, Asda, Waitrose and Sainsbury’s to find the cheapest deals.

When buying other products, such as household appliances, gadgets, or books, CDs or DVDs, use a shopbot to shop around for you. There are a number of sites, including Kelkoo, Pricerunner and Shopping.com, which will scour the market to find you the cheapest price. It’s also possible to boost savings by getting paid to shop online by using cashback sites.

To cut fuel costs, visit petrolprices.com - enter your postcode and how far you’re willing to travel, and it will list the days cheapest petrol stations for all types of fuel.

For some expenses you may be able to make savings by teaming up with other people to share your resources.

Savings

The most immediate effect of inflation is certainly on your day-to -day spending. However, unless you take steps to inflation-proof your savings, you could find the value of your money is gradually eroded over time too. “Many people fear the stockmarket because of the risk of losing their money, but the same risk is true of holding money in cash due to inflation,” explains Klonowksi.

A inflation rate of 2.2%, for example, means that £3,000 five years ago is worth just £2,684 today. According to Moneyfacts this means a basic-rate taxpayer will need to earn at least 2.75% in interest to beat inflation, while higher-rate taxpayers will need to earn at least 3.67% before their money even starts to grow in real terms. And that's only if inflation is at 2.2%!

Gavin Haynes, managing director of Whitechurch Securities says bonds, fixed-interest and cash based investments will all suffer as a result of inflation. “These are not a safe place to be when prices are rising. It’s important to build a well-balanced portfolio, and that includes equities.”

Haynes likes equity income funds, because they aim to produce dividends to boost annual growth greater than inflation. He favours equity income funds from Artemis, Sigma and Rathbones. “Gold is also a good place to be to beat inflation” adds Haynes. He recommends the Merrill Lynch Gold and General fund, or Exchange Traded Funds (ETFs) to get exposure to gold.

If you still don’t like the idea of equities however, Haynes suggests the risk averse could go for index-linked gilts – government bonds – or National Savings and Investment products, which are also index-linked.

Of course it always makes sense to keep some money in cash savings accounts. Just how much will depend on your circumstances and attitude to risk – but, however much you have in the bank it pays to remember that it’s unlikely to grow as fast as other investments so you really do need to make it work as hard as you can. That means earning the best rate of interest you can and making the most of your ISA allowance to protect your cash from the taxman.

Finally don’t just need to think about inflation when choosing your investments, you also need to incorporate it into your financial planning, warns Klonowski. This is because you’ll have to make assumptions on the cost of living in the future. He advisers investors to err on the side of caution by making decisions based on a rate higher than the official rate of inflation. “Retirement income for example, needs to rise year on year, so it makes sense to allow for more inflation than not enough.”

Any index-linked contributions we make also have the potential to depreciate in value. “State pension contributions are index-linked to the RPI, but if the true cost of living is rising more than this, you really need to increase your contributions by making provisions elsewhere.”

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