Prepare your finances for the growing threat of inflation

As inflation reaches an 11-year high, David Prosser looks at how to plan ahead for rising prices

Is inflation back to haunt the UK? Gordon Brown has claimed to have rid the country of boom-and-bust economics, but inflation has hit an 11-year high, the Office for National Statistics (ONS) confirmed this week. At 3 per cent, inflation remains low by historical standards, but for the first time in a generation, rising prices could again be a threat to your family finances.

SPENDING

The headline rate of inflation is now 3 per cent, but other measures suggest prices may be rising more quickly. The Retail Prices Index (RPI), which includes costs such as mortgage interest and council tax, shows annual inflation of 4.4 per cent.

For some people, inflation may be even higher. The ONS has a tool on its website that allows you to work out your individual inflation rate. For those with big mortgages, or people who spend a good deal of their income on gas and electricity bills, inflation may be double the official rates.

"Take stock of your spending," says Anna Bowes of financial adviser AWD Chase de Vere. "If you can save money in any way possible, now is the time to do so."

MORTGAGES

The Bank of England's key tool in controlling inflation is interest rates. There have been three base-rate rises in the past six months and there is a good chance the cost of mortgages will rise further this year. The obvious response is to fix your mortgage rate before costs go up. But lenders know rates may rise again, too - so, many have now withdrawn their best deals.

"Borrowers who are stretched to the limit may find a fixed rate a necessity to avoid getting into real difficulties," says Cath Hearnden of mortgage adviser My Mortgage Direct. "But for the better off, who can manage another half per cent rise, sticking it out with a good discount or tracker could prove the sensible option in the longer term."

SAVINGS

Savings rates should improve with rising inflation, particularly following base-rate increases, but think about the interest you're earning after the effects of tax and inflation. With the RPI at 4.4 per cent, a basic-rate taxpayer needs to earn 5.5 per cent on their money to break even in real terms, rising to 7.33 per cent for a higher-rate taxpayer.

National Savings & Investments, the Government-backed savings bank, offers tax-free Index-Linked Certificates, which offer a rate of RPI plus 1.15 per cent or 1.1 per cent over three or five years respectively. This is one way to be sure your savings will be no worse off because of inflation and tax.

Also consider other tax-free savings accounts, such as cash individual savings accounts (ISAs). But once these options are exhausted, Bowes says: "You may need to review how much money you hold in cash."

INVESTMENTS

"Only equities, and to a lesser extent property, have the potential to produce returns that either match or beat inflation over the longer term," argues Paul Ilott of financial adviser Bates Investment. Savers and investors may now have to be prepared to take on more risk, he says. Ilott recommends equity income funds as a hedge against higher inflation. During the past 10 years, he says, the income paid out by the average fund has risen 35 per cent, compared with cumulative inflation of 30 per cent.

In addition, while cash in the building society has remained constant in value, stripping out interest payments, the capital value of the typical equity fund has more than doubled.

Andy Brough, a fund manager at Schroders, adds: "As an investor, you can profit from inflation - look for companies that are putting up prices because demand for their products is strong. Take public transport, for instance: when the cost of tickets goes up every year, it makes sense to be invested in companies like Go-Ahead Group and Stagecoach.

PENSIONS

Philippa Gee of independent financial adviser Torquil Clark is concerned too many savers buy level annuities when they reach retirement age.

An annuity is a guaranteed income for life, paid for by your private pension savings, but there are different types available. Level annuities pay the highest possible starting pension income, but this income never rises.

Over time, inflation will have the effect of eroding the real value of a level annuity. "An inflation-linked annuity may be a much better bet [with] rising inflation," Gee advises.

The best fixed-rate mortgages

* If you are certain you want to fix your mortgage rate now, do so as soon as possible. A slew of lenders withdrew their best rates from the market this week and more are certain to follow.

* Katie Tucker, a product specialist at independent mortgage adviser John Charcol, points out: "Many lenders' mortgage offers last for three or six months, so even if you have a while until your current mortgage rate expires you can reserve funds on the replacement by applying now."

* Tucker suggests Nationwide Building Society, which offers a two-year fixed rate of 4.84 per cent for purchasers or 4.94 per cent for people remortgaging. Both have a £799 arrangement fee. It also has slightly higher rates with lower fees, which may work out cheaper for people with smaller mortgages.

* Cheltenham & Gloucester and Lloyds TSB both offer a 5.09 per cent five-year fixed rate with an arrangement fee of £999, Tucker points out. This comes with free valuations and legal work on remortgages.