Saving, spending or investing? Find out what inflation means for you.
Inflation is the general increase in prices over time, and it affects all the goods and services around us. From mortgages, cars and train tickets, all the way down to the penny sweets we remember buying as kids. As inflation goes up, the purchasing power of our money goes down, as we can buy less of what we could before.
So, inflation must be bad, right?
While paying more for goods and services seems like something to avoid, inflation is often a sign that the economy is working well, with sufficient consumer demand to stimulate economic growth. As an example, if we know that the price of a car is likely to increase over time, we are inclined to make that purchase sooner to secure the lower price. On the flip side, if inflation is too low or negative, consumers may put off spending as they expect prices to fall.
Causes of inflation
Several factors affect inflation within an economy, but the core of it is the interaction between supply and demand. One of the most common reasons for increasing prices is when the demand for goods and services outweighs the supply.
Take the recent rise in house prices. Policies such as the stamp duty holiday and the increase in home working have led to an increased demand for properties. Combine this with a more rigid supply, and the result is increased prices (10.2% over the year to March 2021) 1.
Then we have inflation on the supply side, where increasing production costs drive prices higher. This has been witnessed globally as businesses emerge from the pandemic, where supply chain bottlenecks have contributed to a short-term spike in inflation.
Measures of inflation
The consumer prices index (CPI) tracks the changes in prices of a ‘basket’ of goods and services consumed by the typical household (such as food, clothing and transport) 2.
The Bank of England has an inflation (CPI) target of 2% 3. This is considered low and stable and makes planning for future purchases much easier. Central banks around the world aim for similar rates, but as economies relax their Covid restrictions, we are starting to see inflation rise above targets 4.
To combat this rising inflation, central banks may tighten monetary policy (policies used to influence the supply of money and the cost of borrowing), namely by increasing interest rates. For the consumer, this means a higher cost of borrowing and an increased incentive to save.
This is where the economic debate rages, not about the level of inflation over the coming months, but the potential staying power of higher inflation. In the UK, US and Europe, annual inflation measures can now compare prices in lockdown to prices in a growing economy. Therefore, the rising inflation figures recorded in April and May posed little concern to central banks and financial markets.
The possibility of high, sustained inflation is a far cry from the challenges of the last decade, where low inflation brought the potential of fighting deflation in the future. The major voices in developed markets believe that the higher inflation predicted throughout the year is an anomaly created by the pandemic.
This means central banks are unlikely to be spooked into raising interest rates, in the short-term at least.
The Holden & Partners view
We expect to see higher inflation for the foreseeable future, but not at a sustained level whereby central banks will be forced to raise interest rates.
The stimulus of economies, whilst massive in scale, will not send prices skyrocketing if funds do not then circulate in the economy (for example if there is no increase in spending). High unemployment, intense competition and the collapse of trade unions will all provide a headwind for inflation in the medium-term 5. In addition, the long-term deflationary pressures are still present in the developed economies; driven by ageing demographics, mounting debt and technological advancements 6. Now, the threat of deflation has been replaced by the possibility of high sustained inflation, which is an easier problem to solve when interest rates are near zero and central banks have mountains of assets on their balance sheets.
How our portfolios are positioned to deal with inflation
Our exposure to a range of asset classes (including equities, infrastructure, property and index-linked credit) aims to offer inflation hedging properties and optimal risk-adjusted returns. We recently added US TIPS (Treasury inflation-protected securities) to our models, which offers strong inflation-linked returns at a shorter term than UK index-linked gilts.
Equities are traditionally considered as a mitigation against steadily rising inflation, as companies can change prices thereby protecting their revenues. Hedging, or mitigating against, a rise in inflation can be complex, given that inflation can take several forms that have different economic impacts.
Whilst not held within our Sustainable portfolios, precious metals can act as a strong hedge for extreme or unforeseen high inflation, due to the higher perceived intrinsic value of precious metals over fiat currencies (that is, currencies not backed by physical commodities, such as gold).
We maintain defensive fixed income holdings in both the government and investment-grade sectors that could be vulnerable to rising inflation. However, these assets provide important defensive characteristics to the models, which was evident throughout the first two quarters of 2020.
How does inflation feature in financial planning?
Whilst we continue to position our portfolios in line with our view of short-term inflation, it is worth remembering the impact it has on savers and spenders over the long term.
For most savers, inflation is a good reason to invest in stocks and shares, although it is important to keep sufficient cash reserves in place to cover any unforeseen expenditure before investing. Goods and services will almost certainly get more expensive over time, so keeping money in your bank account for longer-term objectives, whilst interest rates remain very low, doesn’t make sense. In most cases, over recent years, the effect of holding money in cash will have been a negative real rate of return.
This shows the importance of having a sound investment strategy to grow your money and retain spending power over time. A key part of our financial planning service is to make sure your funds are invested in a manner suiting your investment preferences, your life plans, and the degree of investment risk appropriate for your circumstances.
Inflation in retirement
Inflation is also a challenge for those in retirement, which is usually when less risk can be taken. Historically, popular sources of retirement income have included interest from savings and fixed annuity incomes, both of which can lose purchasing power in real terms during someone’s lifetime.
A retirement plan includes several assumptions, including for inflation. Whether retirement is stopping work completely at 65, or a more gradual process, your plan should factor in how inflation could affect your ability to enjoy the lifestyle you want.
Our financial planners explore these options so that you can make informed decisions. Critically, working with a financial planner on an ongoing basis also means you can adjust your plan so that risks, such as increased inflation, are addressed and acted on in good time.
Do contact us if you’d like to discuss any aspect of your financial planning.
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Please note that any thresholds, allowances, percentage rates and tax legislation stated may change in the future. The content of this communication is for your general information and use only; it is not intended to address your particular requirements. This communication should not be deemed to be, or constitute, advice. You should not take any action without having spoken with your usual adviser.