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Why inflation is important and how it affects investors

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Investors need to keep an eye on inflation because it affects different types of investments in in different ways.

by Gavin Lumsden on Feb 01, 2013 at 11:53

Why inflation is important and how it affects investors

The aim of investing is to grow your money ahead of inflation so that you have enough to live on when you retire. The trouble is different types of investment behave differently depending on what the level of inflation is.

This is the latest video in The Lolly Investor Programme series, aimed at explaining the basics of investing to beginners. 

Can't watch now? You can read my video script instead.

Hello, the whole point of investing is to protect your money from inflation so that you have enough to live on when you retire.

What makes this difficult is that different types of investment behave differently depending on whether inflation is high or low, or whether there is deflation, which is the opposite of inflation when prices are falling.

Inflation is an important issue to consider right now because the Bank of England is thinking of reviewing its policy target of keeping inflation at 2%.

Outgoing Bank of England governor Sir Mervyn King and his successor, the George Clooney lookalike Mark Carney, have both talked about whether the Bank should pay more attention to achieving growth in the UK economy.

This has got some alarm bells ringing. The Bank’s current target already requires it to balance the need to keep inflation in check with the need to have growth in the economy.

Modifying the policy target could risk the Bank being seen as soft on inflation, which would have huge implications for all our finances.

Mervyn King insists he is not soft on inflation.

However, under his watch the Bank’s record on forecasting inflation has been poor. In recent years inflation has generally proved to be higher than the Bank said it would be.

Britain’s most pressing need is to cut its £1 trillion pound debt mountain.

The most effective way to do this would be to restore economic growth.

But there is another way.

We could inflate our debts away. There’s a sneaking suspicion that’s what the Bank wants to do.

How would inflation reduce our debts?

We all know inflation increases the price of goods and services we buy.

For example, the price of a pint of milk rose by a third in the 10 years between 1999 and 2009, from 34p to 45p.

That’s happening all over the place.

As time passes inflation means your money is worth less.

The same happens to your debts: their real value falls under inflation, making them easier to pay off.

Suddenly inflation doesn't sound so bad!

Before you decide to become a fan of inflation bear in mind interest rates also rise with inflation, so the cost of servicing a lot of debt goes up too.

Nevertheless, this shows why some people think the Bank of England is prepared to let inflation to continue to rise above ‘expectations’.

And don’t forget the £375 billion of new money the Bank of England has created with ‘quantitative easing’ in response to the financial crisis.

The Bank has massively increased the ‘monetary base’ of the economy.

This has avoided a Depression but all that extra money sloshing around could risk a spike in inflation, unless the Bank can find a way of removing it once the economy starts to recover.

So what happens to investors if we get a bit more inflation?

Last year two US academics Kenneth Washer and Lee Dunham published an article looking at the performance of the main asset classes in relation to inflation between 1972 and 2011.

Their results are very interesting and although based on US markets, are relevant to UK investors.

In times of moderate inflation between 1 and 2% Washer and Dunham found shares were the best asset class.

On average shares rose 1.4% above the rate of inflation in each quarter when inflation was moderate.

This is probably because companies can push through price increases on their products and continue to grow their dividends.

Shares beat gold and property shares, although their returns were positive.

Bonds did worst of all, losing money in real terms as they returned 0.5% less per quarter than the rate of inflation.

In periods of higher inflation the investment picture changes entirely.

In quarters where inflation ran at more than 2% there was only one winner – gold returned an average of 3.2% more than inflation in these periods.

Bonds again did badly as their fixed rate of interest is eroded by inflation.

But property shares and other shares did worst of all. High inflation made their dividends less attractive and share prices fell, returning 1.4% on average less than the rate of inflation in the case of shares.

These are challenging findings for investors. Property shares and ordinary shares only beat gold in periods of low inflation.

And in quarters where there was deflation or falling prices shares did surprisingly well. On average they returned 6.5% above the level of deflation, which averaged at minus 0.7%.

Deflationary periods were the best for bonds which returned 3.4% above the level at which prices were falling in each quarter.
To sum up, bonds are a very poor defence against inflation but shares do actually worse when inflation is high.

Gold is a brilliant defence against inflation which is why there has been so much investor interest in the precious metal in recent years.

Investors can only hope we find the growth solution to our debt problem. Using inflation to erode our debts would hit all our pension plans. 

6 comments so far. Why not have your say?

Pilgrim

Feb 02, 2013 at 02:41

The problem with looking at history is that history never quite repeats itself. The degree to which the future may resemble the past is also influenced by major structural changes. For the past several decades interest rates have been on a steady downward trend. Now that tend is over, as the rates cannot move significantly lower. Bank rates in the USA have reduced to near zero, and in the UK the 0.5% bank rate has no useful distance to fall further. At some time in the foreseeable future interest rates are going to move up significantly.

In economic terms we live in a strongly irrational world largely driven by populist politics. The economic equivalent of the force of gravity will eventually have its effect, but not for so long as our political class can possibly delay it. And with a new UK election appearing on the distant horizon the politicians will be very keen to postpone the moment of reckoning to the other side of the next election if possible.

Against this background the value of the £ has been following a crazy path against the currency of our principal trading partners in the European Union. Since the summer the pound exchange rate has varied from a high point in the region of 1.29 euro to the latest level of 1.15 euros, a fall in relative value of over 10% in a few months. The instability in currency exchange rate clearly operates strongly against the interests of British exporters. It puts a brake on trade because of the costs and uncertainties it introduces. Of course the soaring value of the pound in midsummer 2012 reduced the pound cost of food and other products sourced from Europe, and thus provided a short term reduction in the inflationary pressures felt within the UK. But now we are on the opposite tack. January has seen the pound falling in what is increasingly looking like a free fall. The consequence is obvious. Inflation is likely to take off significantly in the coming months and even more so if the BoE continues with QE in one form or another . Of course a weaker currency can help stimulate UK production. But there is an appreciable delay before any currency devaluation advantage can feed its way through. In the meanwhile the increased cost of imports will be felt first with the result that the trade deficit of the UK will increase, and this in turn will put further pressure on the pound. The situation does not appear stable and one can imagine a situation in which the pound enters a downward spiral accompanied by a very significant increase in the level of inflation. This situation, if it arises will be a financial crises created through the ineptitude of the BoE and of the senior partners in the coalition. Telling our principal trading partners that we are considering tearing up our treaty relationships with them is not the best way of reassuring markets or encouraging trade.

So, miracles apart, inflation is coming whether the BoE likes it or not. Interest rates will probably stay low because any increase will promote a fresh round repossessions and send the housing market down strongly, a politically unacceptable situation.

In summary,

1) The UK rate of Inflation is likely to increase whatever the BoE does.

2) The findings from the historical review are interesting, but only provide a poor guide to the future because we are in a different structural situation with rising interest rates.

3) Euroland may have been passing through a year of financial crisis, but the BoE should have intervened more forcefully to damp out the extremes of fluctuation in exchange rates.

4). David Cameron's disastrous attempt to find a middle road between UKIP and pro-European elements within the conservatives has put party interest above the national interest, with immediate adverse consequences for UK trade and influence within Europe, and the value of sterling.

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barcombeboy

Feb 02, 2013 at 09:12

Lovely post. High inflation, low interest rates. Right, so borrow quick, do up your house and then sell, repeat... before it all comes tumbling down?

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Rob Walker

Feb 02, 2013 at 09:17

Analysing quarters and seeing which investment type did best against inflation is a nice academic excercise, but a lot of us investors have experienced the worst financial crash in our lifetime, interest rates for cash at almost zero and an economy that's harder to get started than a second-hand Reliant Robin. Even with a Buoyan FTSE I wouldn't want to predict the best place for my cash right now, and deep down, I suspect most of these so-called financial pundits would would agree. The general lack of enthusiasm for Bonds does, however, suggest it is probably still an attractive option for the investor with some spare cash.

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chazza

Feb 02, 2013 at 10:11

Well said, Pilgrim. I do think Cameron has sunk the pound with all the consequences you describe. To salvage a little from this sinking ship, the best the private investor can do is shift money abroad or invest in UK listed overseas investment funds / trusts. It is very hard to see the bottom for the pound. Since this is a UK-made problem, I don't think US history will be much of a guide, especially since the Washer and Dunham analysis is of a period during most of which the US was a much more dominant economic influence than it is now. Gold might be an option if inflation were to become global, but there is little sign of that yet, and UK inflation alone is likely to be too small an influence to move the global price of gold.

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Chartered Accountant

Feb 02, 2013 at 11:58

One effect of rising inflation would be to force an increase in bond yields and this would have an interesting knock-on effect in reducing the quantified values on pension fund liabilities for surviving final salary schemes, potentially reducing or eliminating deficits with a corresponding positive impact on corporate balance sheets. Just a thought!

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Robert Hope

Feb 03, 2013 at 08:32

Please pass Pilgrim's analysis of the situation on to David Cameron and leaders of the B. of E. as he has hit the nail on the head!

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