INFLATION UPDATE

How could rising inflation affect me?

  • 05 July 2021
  • 10 minutes

With the pandemic still holding a grip over the country, along with the resurgence in case rates due to the Indian variant, you may have missed the news that the Consumer Prices Index (CPI) has risen from 1.5% in April to 2.1% in May. That is now above the Bank of England’s 2% target for the first time since July 2019, but could this be just the beginning?

What is inflation?

Inflation is a measure of how much the average price of goods and services has increased over time.

To measure inflation, the cost of things today are often compared to how much they cost a year ago. The average increase in prices is known as the inflation rate.

How is inflation measured?

Each month, the Office for National Statistics (ONS) calculates the cost of a typical basket of goods based on consumer consumption patterns. This provides the Consumer Price Index. CPI is the measure of inflation as it tracks how consumers’ purchasing power is affected by rising prices.

The Government has set a 2% inflation target for the UK.

If inflation rises too much above this target, it can be tough for businesses to set the right prices and for consumers to budget effectively.

On the other hand, if inflation is too low it can put people off spending because they expect prices to fall. The reduction in spending is bad news for businesses who may have to lose employees, or even close, as a result.

What is core inflation?

Like CPI, core inflation is the change in the costs of goods and services. However, core inflation does not include prices from the food and energy sectors. This is because the costs of these goods and services tend to be more volatile.

Core inflation is an important measure as it indicates the impact of rising prices on consumer income.

What has driven the increase in inflation?

The increase in both the UK and the US (where inflation has risen to over 4%) is due to reflationary effect. This is when prices increase as an economy is striving to achieve full employment and growth as we are witnessing now with the economy starting to re-open as COVID-19 restrictions are eased.

However, much of the increase is due to base effect inflation as people start to return to normal, so it's likely to be a one off effect. Although there is slack in the economy so this is likely to be taken up quickly and unemployment will start to fall. This could cause core inflation to rise in the second half of the year.

How will this affect interest rates?

Controlling interest rates is one of the key tools for central banks to either boost or slow down the economy. At the moment interest rates are at historically low levels. In the US, we forecast two rate increases by end of 2023. It's also predicted that the Federal Reserve, the US central bank, will gradually reduce support for the economy as the economic scene improves by tapering their bond buying programme. This would raise bond prices and lower their yields, but could also send the economy into a recession if activities are tapered too quickly.

In Europe, inflation is likely to be allowed to run above targeted levels for longer to ensure the recovery has fully taken hold.

How does this impact my savings?

The obvious benefit of cash is that it will always retain its absolute value. However, the disadvantage is that the value can be eroded over time by inflation.

The chart below shows the purchasing power lost on a £100,000 deposit account earning 0.4%, with inflation at 2%. The loss each year in real value is 1.6%

Source: Schroders Personal Wealth, June 2020. Past performance is not a reliable indicator of future results.

However, your savings are not designed to grow your money, but rather provide a financial safety net should you ever need it.

How does rising inflation affect markets?

Inflation can be good for holders of assets, if their values rise faster than the general level of inflation. However, it can be bad for anyone with a fixed income.

Bonds are therefore an obvious casualty. Bonds are a type of loan by a investor to a borrower (which is typically the Government or a company). They typically pay a fixed interest rate (coupon) to owners of the bonds.

Their fixed stream of interest payments become less valuable as the overall cost of goods and services accelerates, sending yields higher and bond prices lower to compensate.

In theory, equities can be more appealing when inflation increases as a rise in prices should correspond to an increase in nominal revenues and therefore boost share prices.

Commodities, such as raw materials and energy, are a source of input costs for companies as well as a key component of inflation indices. So by definition, they should perform well when inflation rises.

Is inflation expected to rise for much longer?

Economists expect CPI inflation to remain at or above its 2% target for some time. It's likely to increase over the coming months due to previous sharp rises in global commodity prices (particularly oil prices) and stronger demand conditions for goods and services, as lockdown restrictions continue to be lifted.

However, as the base effects of this year’s energy price moves drop out of the equation, headline inflation (not adjusted to remove highly volatile figures) is likely to shift back below the 2% target next year.

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