Over the past few months, inflation – the rate at which the price of goods and services rises – has been heading upwards. Last week, it was announced that US inflation had reached 7.5%. This week, the latest data showed that UK inflation had hit 5.5% in January.*
Given that both the UK and US central banks target long-run inflation of 2%, these figures look dramatically off-course. But why is inflation so high at the moment, and why does this seem to have alarmed financial markets so much?
Why has inflation risen?
Inflation is either surprisingly high or not very high at all, depending entirely on your time horizon. In developed world economies, we have grown used to inflation in the low single digits over the past few years (since around 2014). However, many reading this piece will remember the 1970s, when UK inflation measured in double-digit figures at key points in the decade. Nevertheless, it is reasonable to express concern when a key economic indicator like inflation alters quickly. So, what has changed?
Inflation is the product of a range of factors, including economic activity, commodity and import prices, changes in global supply chains, and shifts in consumer demand. All of these factors have endured a wild ride over the past two years, and will take some time to normalise in the wake of the global pandemic. In many ways, higher inflation can be viewed as a natural by-product of a perfect storm of supply chain squeezes and the release of consumer demand (pent up during population lockdowns), which are distorting price dynamics in the world economy.
Will inflation remain this high forever?
The extent of inflationary pressures in the global economy took investors (including us) by surprise in 2021. Financial markets are notoriously averse to change, so short-term noise in the economic landscape has unnerved them. This has created additional volatility in asset prices, as markets adjust to account for changes in the inflation picture, and – most importantly – their expectations for the likely central bank response (i.e. interest rate hikes).
Source: Office for National Statistics and Bank of England.
Figures as at 31 December 1979 and 16 February 2022 respectively.
At the moment, financial markets are also adjusting to a ‘mid-cycle’ phase in the global economic cycle. This kind of environment typically emerges on the heels of the initial burst of economic recovery which follows a recession. It can be a good period for higher risk asset types like shares, but also tends to come hand in hand with greater volatility in asset prices. So far in 2022, we have seen this turbulence playing out in both stock and bond markets.
It’s also worth noting that share prices do tend to be more volatile when inflation is higher, and the types of shares that do well in a high-inflation environment can be quite different to those which perform well when inflation is low. This means that changes in inflation levels can naturally lead to stock market adjustments, as investors attempt to predict where the economy will go next (and, again, how central banks will respond). In this scenario, the relative positions of shares on the leader board move around, and the overall effect is one of market upheaval.
What does higher inflation mean for people with cash savings?
When we speak to our customers about inflation, we often refer to it as the thief that picks your pocket while you look the other way. This is because, through inflation, the money in your pocket becomes worth a little less than it was before, as its real-world purchasing value falls.
Holding your savings in cash therefore virtually always means losing money in real terms, but especially in environments of higher inflation, when the value of cash relative to the cost of goods and services falls more quickly.
Could interest rates rises make cash savings attractive again?
Low interest rates make it cheaper for households and businesses to increase the amount of money they borrow, which can encourage economic activity. This is why central banks lower (or maintain already low) interest rates when the economy needs a boost. However, low interest rates make it even less rewarding to save money, as they allow cash to generate little in the way of financial returns.
Today, interest rate rises are finally beginning, which would normally spell better news for cash savers, but these are moving up very slowly, and from historic lows.
Back in the late 1970s, rising wages and sky-rocketing oil prices led to sharp moves in inflation. As the decade drew to a close, inflation measured 13.4%. However, the Bank of England’s benchmark interest rate was ratcheted up to 17% in 1979, meaning that cash savers still had the potential to outpace inflation, as their cash delivered returns in excess of price rises. Today, with inflation at 5.5%, and the Bank of England’s benchmark interest rate at 0.5%, it’s clear that we are still a very long way off interest rates making cash savings an attractive source of financial returns. Put simply, waiting out the storm in cash doesn’t hold the appeal – or reward – it once did.
What does higher inflation mean for our investment strategies?
Clearly, a period of higher inflation can be challenging for investors who – like us – manage assets against an inflation-linked benchmark. For this reason, we always view performance figures over longer term, aiming to strip out shorter-term noise and market volatility.
Even taking a longer-term view, though, we are acutely aware that inflation-linked targets can be very hard to beat when inflation is high. Nevertheless, we believe that targeting returns in excess of inflation helps to keep us tightly focused on investment solutions that grow the real-world value of our customers’ wealth, rather than sitting back and letting inflation pick their pockets.
No investment comes without risk, and that includes simply holding onto your wealth in cash. However, we continue to believe that investing across a range of carefully selected asset types, with a clear understanding of the potential risks and rewards involved, is the better option for anyone seeking attractive real-world financial returns over the long run.
* When we talk about inflation in the UK and US, we are usually talking about the Consumer Price Index or CPI – a measure of inflation constructed by taking an average price from a mix of goods and services. The data given above comes from the Office for National Statistics (UK) and the Bureau of Labor Statistics (US).