The fact that recovery seems to be here comes as a relief to all of us. Getting back to work, getting new customers through the door (or at least on the other side of the screen) and generally getting on with life are all overdue.
But recovery may come with a sting in the tail. At Continuum we are looking at the dangers of inflation.
The danger of inflation
Inflation – the phenomenon of rising prices – creeps up and steals your wealth as effectively as any pickpocket. It takes time to work, but it affects everyone, from individuals to businesses to entire countries; in extreme cases, if it is mismanaged, it can derail entire economies. It can happen when demand outpaces supply and is happening now with consumers and businesses crying out for goods, while the supply chains struggle to get back up to speed.
Shortages mean sellers ask more for whatever they have to sell. The recovery may make a period of inflation inevitable.
Fortunately in the UK we are in no danger of hyperinflation, which can make cash worthless overnight, but we are liable to the steady whittling way of the purchasing power of our money by rising prices.
There are various ways to measure inflation, but the most useful measure for most of us is the CPI – Consumer Price Index Inflation, calculated through measuring changes in the cost of a basket of goods that consumers buy every month. It is then quoted as an annual number. For countries like the US and UK that number is targeted by the central banks to be roughly 2% every year.
Inflation means people on fixed incomes, from savings or pensions for example can face hardship as they can no longer afford the lifestyle that they planned. On the other hand, borrowers benefit, as the sum they have to pay back steadily becomes worth less than the amount they borrowed.
The Bank of England is currently forecasting inflation of around 2.5% this year. For financial stability, central banks don’t want consumers to see prices rising that fast. In normal times if they consistently see annual inflation above 2% month after month they will start raising interest rates to dampen demand. This is known as tightening the monetary policy.
But these are not normal times. Central banks such as the Bank of England may not be able to impose an interest hike now, for fear of derailing the recovery.
So what happens as the recovery gains pace?
Inflation is currently high, but it could be a short-lived or ‘transitory’ issue.
There are several reasons to hope so. The first is the nature of the COVID crisis, which meant we could not spend money as shops, pubs and restaurants were closed. Inflation data from a year ago was artificially low. Now, many of us have surplus money to spend. Once the recovery settles down and we reach our normal level of spending, inflation could fall away.
The second reason is the result of the supply chain problems which should go away once suppliers are back up to full speed.
Finally, the generosity of governments around the world who ‘printed money’ to keep their economies afloat mean that the system is awash with cash, which markets are perfectly designed to absorb with higher prices. When governments wind down support, the inflationary pressure may be removed.
However, there are no guarantees, and inflation could not only be inevitable, it could be welcomed by governments who need increased tax revenues to pay for their deficits that they have been plunged into.
You need to be prepared for inflation to continue as the recovery gains pace.
How to manage money if inflation stays high
The purchasing power of paper money will decrease by the inflation rate. This means that cash savings are an expensive luxury. Finding a savings account with an interest rate that can keep pace with inflation is unlikely. The real world value of the money you stash will be eaten away.
High inflation will also eat into the returns from fixed income products like bonds, unless they are inflation linked.
However, investments such as shares may be affected in a very different way. Over the short term stocks may show some impact as companies struggle to pass on rising costs. Longer term, falling cash values may make shares a good hedge against inflation. Real assets such as property and some commodities should actually benefit from rising prices.
Investments, where your money is used to buy something rather than kept as cash savings may act to preserve and hopefully increase its real value. Becoming an investor is easier than you might think. We can help you find tax-free funds such as Stock and Shares ISAs where your money will be invested by expert managers with the aim of providing the growth or the income you need.
To find out more, simply contact us today.
The information contained in this article is based on the opinion of Continuum and does not constitute financial advice or a recommendation to suitable investment strategy, you should seek independent financial advice before embarking on any course of action.
When investing your capital is at risk. The value of your investment can go down as well as up.