The return of inflation?
Latest (August) figures for CPI represent the higher monthly rise ever recorded by the Office for National Statistics. Should you be worried? We look at why inflation matters, and how you can prepare to cope in a higher inflation environment.
In September 2020, annual inflation in the UK was running at 0.5% on the CPI measure and 1.1% using the old RPI yardstick. At the time, price rises were the least of the economic concerns. Wind forward 12 months and inflation has become a hot topic. The latest (August) figures are 3.2% CPI and 4.8% RPI. The increase was the highest monthly CPI rise ever recorded by the Office for National Statistics (ONS) and brings the inflation rate to the level last seen in March 2021. As the graph shows, 2021 has been something of an inflationary renaissance.
RPI and CPI figures, 2010 - 2021 (source: ONS)
Not only here…
Inflation was once known as the ‘British disease’, reflecting the problems of the 1970s when annual price increases topped 20%. This time around the UK is not alone in experiencing a jump in prices. Across the Atlantic, the USA has seen inflation leap from 1.4% last September to a 13-year high of 5.4% in June and July 2021, before easing to 5.3% in August. The Eurozone, which has long struggled to meet its inflation target has joined in, too: prices were falling by 0.3% a year in September 2020, while they are now rising at 3%, in August 2021 - the highest since November 2011 and well above the European Central Bank’s new central target of 2%.
‘Transitory’, say the central bankers…
The favourite word used by central bankers to describe the uptick in inflation is ‘transitory’. There is a case to be made for that view:
· Annual inflation is a measure of current prices against those a year ago. Think back twelve months and there are some prices that were driven down by the pandemic, which cut or even eliminated demand. Look across two years and the price of an item might have changed little, but the movement during the period could be V-shaped, with the last 12 months’ sharp bounce back. ‘Base effects’ is the economists’ term for this statistical quirk. Another year and they could automatically disappear.
· The pandemic has also created supply chain issues which have driven up prices as demand recovered. A good example has been the supply of computer chips used in car production. One vehicle may need up to 1,500 chips and these have been in short supply, with a knock-on effect for car production. In the absence of sufficient new vehicles, secondhand car prices have jumped – by over 18% in the year to August in the UK. Once more, the argument is in another 12 months supply chains will have re-established and the problem will have disappeared.
…But are they right?
The argument against the central bankers’ optimism is partly that ‘they-would-say-that-wouldn’t-they?’ If they thought that the spike in inflation was more than a blip, then the central bankers they would need to reverse their current policies of keeping interest rates around zero and buying large quantities of their Governments’ bonds. Such a change would have serious consequences for the Governments concerned, all of which have borrowed heavily in response to the pandemic and can ill-afford a higher interest bill.
The worry is that price inflation is already starting to work through into wage increases, although there are distortions here, too – in July average pay in the UK was up 8.3% year on year. Wage rises could then lead to further prices rises and so the spiral begins…
Why inflation matters
For the last 20 years to the end of 2020, CPI inflation averaged 2.1% and RPI inflation 2.9%. That has been close enough to the Bank of England’s target to be of no concern. An inflation rate of 4%-5% would start to have a serious impact on investment and financial planning. At 5%, purchasing power halves over 14 years, whereas at 2% the same erosion takes place across 35 years.
Higher inflation would mean also probably mean higher interest rates. That could drive down the value of many investments, simply because the higher the interest rate, the lower the discounted value of future investment income.
As far as possible, your financial planning – from basic life cover to portfolio investment – should take account of inflation. Recent decades of low inflation have reduced the cost of ignoring this principle, but it may prove an expensive error going forward – do you want your retirement living standards to halve every 14 years..?
Talk to us about how well your current plans would cope with higher inflation and what actions you can take to build in the necessary protection.