Higher inflation: what it means and how to aim to survive it

  • Jo Marshall
  • 10 May 2022
  • 10 mins reading time

American consumers are paying 8.5% more today for everyday goods than a year ago. That’s the highest rate of price increases in more than 40 years. In the UK, the year-on-year increase in prices for March 2022 is 7.0%, again the highest rate in decades (1).

Inflation is being seen all around the world as prices of food, fuel, electricity and many other items that make up our routine shopping are going up fast. This marks a distinct change. In recent memory, inflation in most developed economies has been low. So what’s changed, and what does it mean for investors?

What is inflation?

Inflation describes a change in prices. Where official consumer inflation statistics are provided on a national basis (such as the figures for the US or UK above), they are usually calculated by governments. They work out price changes by tracking a basket of commonly-bought items. These will include food and drink, clothing, footwear, transport and energy costs.

There are other types of inflation measures. Producer price inflation, for instance, tracks the prices manufacturers pay for the raw materials needed to make their goods. There are also measures for house price inflation or energy inflation.

If the inflation rate is being reported as at 5% year-on-year, it means that prices in general are 5% higher than they were this time last year.

From 5p to 50p in five decades: real-life price rise of a pint of milk

In January 1971 the average price of a pint of milk in the UK was just 5p. It remained roughly that level until 1975, after which it crept up gradually to just under 40p in the 1990s. The steepest increases have come recently. In April 2021 a pint of milk cost 42p. In March 2022, that reached 50p: a 19% increase in less than a year (2).

What causes inflation?

Inflation has several potential causes. Economists talk of two main types: ‘cost push’ or ‘demand pull’. If the costs of producing goods and services rise, consumers face increased prices for end-products: this is ‘cost push’. But prices can also rise when the demand for something exceeds the capacity to supply it: this is ‘demand pull’.

Today’s inflation is driven mostly by cost pushes. Energy is a component in most goods and services; when, as now, energy prices rise, producers often need to add the cost to the goods or services they provide. Supply disruption in China and elsewhere, caused by the COVID-19 pandemic, had a similar effect: the supply of components, consumer electronics and auto parts fell, causing their prices to rise.

Why is too much inflation seen as a problem?

The most obvious danger of inflation is that, if prices rise faster than incomes, people can afford to buy fewer goods and services. This can mean a fall in living standards.

In practice, inflation’s negative effects are more subtle, impacting different groups in different ways, and having a broader destabilising effect on societies.

These are just some of the negative effects of inflation:

  • It is generally hardest for those on fixed incomes, such as pensioners

  • Inflation diminishes the value of cash and often discourages saving

  • It can lead to workers demanding higher wages, creating ‘wage-price spiral’ of further inflation

  • It can increase the cost of borrowing, adding to financial pressures on households and businesses

  • It can deter businesses from investing, because future costs are hard to plan for

  • It can reduce the value of a currency against other currencies, making imports more costly

  • It can add to government costs and borrowing, as more provision may need to be made for pensions and other spending

  • In the worst cases, countries suffering from high inflation have to abandon their local currency and adopt the currency of a more stable nation. This happened in Zimbabwe after hyperinflation in 2008 forced the country to use the US dollar (3).

Hurting savers: how the value of cash erodes away

Even low inflation eats away at the purchasing power of cash. In the 21 years since 2000, UK inflation has averaged 2.1%. That’s a small number compared to the current inflation rate of 7%. But £10,000 worth of goods purchased in the year 2000 would have cost £15,347 in 2021 (4).

What’s the link between interest rates and inflation?

Inflation and interest rates are closely tied. This is because interest rates are the key tool used by countries’ central banks (such as the US’s Federal Reserve or the UK’s Bank of England) to control inflation.

So how does this work? Well, most central banks are tasked with keeping inflation below an agreed level. In the UK, this level is 2% (5). When inflation is rising, central banks raise interest rates as their way of controlling it.

Higher interest rates lead to higher borrowing costs and, in turn, less spending. This can dampen inflation. The opposite is also true: if inflation is low and an economy too slow, then central banks might cut interest rates in order to stimulate more borrowing and more spending.

If that’s inflation, what about deflation and stagflation?

Inflation describes a widespread rise in prices. Deflation is the opposite: it describes a period when prices fall.

As with inflation, too much deflation is undesirable. Falling prices can lead to deferred spending and investing, withdrawing demand from the economy and weakening growth.

Stagflation describes an unusual set of circumstances when prices are high or rising but economic growth is weak or falling. This could potentially be what many economies are facing in 2022.

Inflation lessons from history

There are parallels between events today and in the 1970s. Back then, oil shocks pushed up the price of oil, which triggered higher inflation. In the US, inflation rose to 14.8% by 1979 (6).

In the 1970s, central banks were slow to act, partly because raising interest rates is not usually a popular move. Instead they hoped the mere fact that goods and services were getting more expensive would stop people spending. In fact the opposite happened. Consumers spent more because they expected prices to continue rising, which only made prices rise even further.

Eventually policymakers turned to interest rates. In the US, for instance, new Federal Reserve chairman Paul Volker raised interest rates from 10% in 1979 to nearly 18% in 1980 (7).

This time around, policymakers are far more ready to use interest rates to try and tame inflation, not least because central banks are now independent from governments. Economists at Schroders think it unlikely we will experience the same levels of runaway inflation as we did in the 1970s and 1980s. But they do think we may have to go through a period of painful adjustment. This could potentially include undergoing higher unemployment and slower economic growth in an effort to return to a more stable inflationary environment.

Inflation snapshots: the double-digit years

Q: You spent £1,000 in 1970. How much would you need to spend 10 years later (1980) to buy the same quantity of goods?

A: £3,608, at an annual inflation rate of 13.7%

Q: You spent £1,000 in 1975. How much would you need to spend five years later (1980) to buy the same quantity of goods?

A: £1,967, at an annual inflation rate of 14.4%

Q: You spent £1,000 in 1979. How much would you need to spend one year later (1980) to buy the same quantity of goods?

A: £1,180, at an annual inflation rate of 18% (8)

Practical ways investors could limit the harm of inflation

Consumers could potentially guard against rising prices by setting up fixed-cost arrangements for certain outgoings, such as energy bills, loans and mortgages. But what about savings and investments?

As our examples show, cash performs poorly in times when prices are rising. Company shares often hold their value better than cash, but their ability to weather inflation varies according to a range of factors.

Recent Schroders research (9) looked back in history to see how stocks in certain sectors performed during periods of stagflation, as we may be facing in 2022. In other words, it reviewed periods when inflation is higher than average, but when economic growth is slowing. It concluded that:

  • Shares in defensive companies (those selling essential products and services, such as electricity or staple household goods) often hold up better in periods of stagflation.

  • The best-performing stock market sectors during periods of stagflation (10) were utilities, consumer staples and real estate.

Some investments, such as inflation-linked bonds, are explicitly designed to provide some protection against inflation. But demand for these types of investments can increase during inflationary periods. This can push up their prices and so reduce their effectiveness at countering inflation.

We believe that holding a diversified range of assets can be an effective way to provide some protection against inflation. These assets could include shares, commodities (such as gold) and property. But the holdings would need to be in line with your particular circumstances. A financial adviser can help you find a blend of investments that meet your particular requirements.

Jo Marshall is an investment writer at Schroders

(1) US Bureau of Labor Statistics, Consumer Price Index, March 2022. Office for National Statistics, Consumer price inflation, UK: March 2022.

(2) Office for National Statistics, RPI: Ave price - Milk: Pasteurised, per pint, 13 April 2022.

(3) Financial Times, Zimbabwe doubles fuel price as currency crisis hits supplies, 13 January 2019.

(4) Bank of England, Inflation calculator, 6 May 2022.

(5) Bank of England, Monetary policy, 17 March 2022.

(6) US Bureau of Labor Statistics, Monthly Labor Review, April 2014.

(7), Federal Funds Rate – 62 Year Historical Chart, 25 April 2022.

(8) Bank of England, Inflation calculator, 7 April 2022

(9) Schroders, What does stagflation mean for your equity portfolio?, 28 March 2022

(10) Schroders Economics and Strategic Research Unit, data from 1995 to December 2021.

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