Understanding inflation

James Cridland of Coleridge Wealth Management in front of Clevedon Pier and beach

James Cridland of Coleridge Wealth Management - Credit: Coleridge Wealth Management

As the Covid-19 restrictions have gradually eased, and consumers have been able to leave their homes and spend their savings, ‘inflation’ has become an increasingly common sight in the financial news. But what is causing this increase, and is it a cause for concern? 

What is inflation? 

Inflation measures the change in price levels, and results in money losing its purchasing power over time. In the UK, the Office for National Statistics measures inflation, collecting 180,000 prices of 700 items as part of a sample ‘basket of goods’, measuring price changes over time. These items include clothing and footwear, food and drink, transport and restaurants. 

Governments and central banks want a certain level of inflation to help the economy grow. If prices are gradually increasing, it encourages people to spend now rather than later, to avoid future price rises. It also allows companies to increase their prices and wages, to grow, and to pay down their debt. 

On the other hand, the effects of runaway inflation are well known. It can wipe out purchasing power – as the value of a currency falls faster than people can spend their salary, leading to concrete assets being hoarded – and result in a ‘capital flight’, as people try to take their money out of the country in search of stability. 

Therefore, central banks and governments try to keep inflation at a low, reasonable level. In the UK, the US, and many other developed economies, the target is two per cent. 

What’s happening now? 

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The past year has seen a dramatic economic slump. Supply chains were severely disrupted, and many consumers were forced to stay at home – often saving. At the same time, governments added liquidity to the system through low interest rates and various loans and payments to companies and individuals. 

As we have moved out of the pandemic, consumers have returned, eager to spend. However, in some cases, supply chains have taken longer to recover, causing prices to increase. A classic example of this is with cars. While demand for used cars has dramatically increased as the lockdown has eased, the stock of used cars remains low, leading to increasing prices. 

As inflation is commonly reported as a comparison to 12 months earlier, the result is that inflation for Q2 2021 is compared to Q2 2020 – when prices were supressed by the first lockdown, and oil prices had collapsed in the face of an OPEC stand-off. 

All this has combined to see inflation increase across much of the Western world. 

One of the ways inflation can be controlled is through increasing interest rates. By increasing the cost of borrowing, consumers and business will have less to spend, thereby also reducing the amount by which businesses can increase the costs of their products. Higher interest rates also make saving cash a more attractive solution. 

Rates are currently at historic lows, hovering just above zero per cent in many Western economies. With inflation creeping up above the two per cent target, some investors are expecting a rate rise in the future. For now though, both the Bank of England and US federal government have described current inflationary trends as ‘transitory’, so are unlikely to make any rash decisions. 

What does this mean for savings? 

With higher inflation, it means you need your money to work harder for you, so you don’t lose purchasing power. Due to the low interest rates, increasing inflation may pose a problem for those with large amounts in cash, so long as interest rates remain below inflation, although cash may still have a place in a portfolio thanks to its flexibility, liquidity and security. 

For those with investments in equities, inflation isn’t necessarily a bad thing. On the one hand, it does mean you need your money to work a bit harder and earn slightly higher returns to generate a return above inflation. And for some companies, it might reduce profits if they are not able to pass on price increases to their customers. 

On the other hand, higher inflation often helps to improve a company’s debt situation, and many companies are able to pass on increased costs straight to the consumer – for example in mobile phones, insurance and utilities. 

This is one of the reasons diversification is so important. No one sector will be the best-performing sector forever, and as inflation increases, some investments may perform better while others may require some adjustment. 

It’s also important to keep in mind that inflation isn’t new. It’s a constant background factor that fund managers have always considered in their strategies. It is also just one in a matrix of considerations fund managers keep track of and respond to over the long term. 

To receive a complimentary guide covering wealth management, retirement planning or inheritance tax planning, contact Coleridge Wealth Management on 01275 430024 or email coleridgewm@sjpp.co.uk 

The value of an investment with St. James's Place will be directly linked to the performance of the funds selected and the value may therefore fall as well as rise. You may get back less than you invested. 

An investment in equities does not provide the security of capital associated with a deposit account with a bank or building society, as the value and income may fall as well as rise. 

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