INFLATION

Written by Hilary Brown, Investment Strategies, Alexander Forbes

Economists and politicians often consider inflation and interest rates as the most important issues in economics. More often than not they discuss inflation in negative terms.

This is understandable as, at a monetary level, inflation is the silent force that makes things cost more and allows our savings to purchase less. However, a more rational thought process could consider inflation as one of the key indicators of a country’s economic well-being. Demand for goods and services puts pricing power back in the hands of manufacturers of goods and services. The enhanced profitability and the wealth that trickles down from this then comes in the form of dividends to shareholders, increased wages to employees, investment in the expansion of a business, and the erosion of longstanding debt (such as mortgages). As such, inflation can have a very positive effect on the nation’s financial wellbeing.

What is Inflation?
In its purest form, inflation is higher prices. But what drives those prices higher? Governments play their part by increasing the supply of currency or credit. This results in more money chasing the same or sometimes a declining amount of goods and services, leading to higher prices and a decrease in the purchasing power of money. It affects the level of state pensions and benefits, as well as the cost of fuel, food and clothes; it also influences the interest rate we get on our savings and the rate we pay on our mortgages.

Why is it important in the UK?
The Bank of England uses the published inflation rate to set interest rates. If the Bank’s Monetary Policy Committee thinks inflation will be above 2.0% in the next 18 months or so, it may increase interest rates to try to subdue it. Conversely, if it thinks inflation is likely to be below 2.0%, it may cut interest rates. The theory is that by making borrowing more expensive, people will borrow less and spend less so that the demand chasing goods and services eases and prices fall.

According to the Office of National Statistics’ Consumer Price Index (CPI) figures released on 15 February 2011, CPI annual inflation – the Government’s target measure – was 4.0% in January, up from 3.7% in December. This meant that CPI spent the whole of 2010 at or above 3.0% and well above the Government’s 2.0% target.

But the Retail Price Index (RPI) stands at 5.1% in the year to January 2011, up from 4.8% in December and is widely seen as a far more accurate reflection of the true rate of inflation as it includes housing costs. The Bank of England is under mounting pressure to raise interest rates to put a lid on inflation before it gets out of control but in March refused to bow to this by keeping interest rates unchanged and at their record low.
An increase would have been a huge relief for Britain’s savers, who have lost out since interest rates dropped to a record low of 0.5% in March 2009. Savers outnumber borrowers by seven to one in Britain.

Global Inflation Situation
Whilst we in the West are concerned over our rate of inflation, the situation in the emerging markets is somewhat more fraught. We have seen, in recent times, riots over the prices of staples such as rice in areas as diverse as Thailand and Algeria.

Some of the inflationary pressure felt by Governments is self-inflicted, the majority is the result of wider global developments that are beyond the control of any government. Figures released on 17 January 2011 by the UN Food and Agriculture Organisation show that global food prices rose to a record high in December, past the previous record of 2008. Many other raw materials are close to or above their pre-crisis peaks. Oil, though still well below the US $140 a barrel it reached in the summer of 2008, is once more above the US $100 level.

There is no escaping the fact that the consequences of this inflation for most developed economies needs to be handled delicately – particularly in the UK, where the inflationary effect of rising commodity prices has been compounded by the devaluation of sterling. With each additional Inflation Report from the Bank of England, the prospect of on-target inflation is pushed further into the future. The investment community is beginning to lose confidence in the Bank of England’s ability to predict the direction of inflation let alone the percentage. Inflationary expectations are rising, as are wage demands (if not yet settlements), despite the threat of unemployment.

Conclusion
The only conclusion available is that the Bank will not be able to hold the line for much longer. Even if the inflation generated by global trends does not increase inflation in the UK, the effect will be almost as bad. As the cost of imports rises there will be less disposable income for domestically produced goods and services. Developed economies will have to learn to cope with higher commodity prices, and adapt their economic models and policies to absorb them.

It is important to remember that inflation is often a sign that an economy is growing. In some situations, little inflation (or even deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it is not so easy to label inflation as either good or bad - it depends on the overall economy as well as your personal situation. Debate continues to rage as to whether inflation or deflation is the bigger threat to the global economy. However, inflation is not a benign factor and we should all be aware of its impact on the pound in our pocket.