If you have bought new clothes, filled the car’s fuel tank or treated yourself to a beer recently, you’ll know what economists confirmed on Wednesday. The price of goods and services, also known as inflation, is rising rapidly.
The annual rate of inflation, as measured by the Consumer Price Index (CPI), more than doubled last month, from 0.7pc to 1.5pc, driven by a surge in the cost of clothes, fuel and energy bills. And economists warn that the rising cost of living has yet more mileage. Investors have not had to worry about an increase for several years, as the rate has remained below the Bank of England’s (BoE) target of 2pc since 2018. But that could be about to change.
A stocks and shares portfolio that performs well when inflation is low may not be such an attractive proposition when it rises. So are rising prices here to stay and, if so, how can investors protect themselves?
Inflation is the decline in what money can buy. Something you could have bought for £100 a year ago would now cost you £101.50. Which, naturally, is bad news for savers, because unless you have a savings account that matches or beats inflation, its value is slowly declining.
Unfortunately, last week’s rise means there is not one single savings account that beats inflation. The best rate you could get is 1.4pc with Shawbrook Bank and that requires locking up your money for five years. Economists describe a steep rise in the cost of living as ‘one of the greatest risks to accumulating wealth’. Borrowers could also suffer if the BoE has to raise interest rates to restrain inflation.
Increase based on temporary factors
Yet the impact of inflation on investors is more subtle. Although a small amount can be a good thing, high or sustained inflation can cause devastation. Just think what happened in Germany in the 1920s.
Historically, stock markets have performed well when inflation has been low and stable, in the 1 to 4pc range. Hamish Baillie, director at investment firm Ruffer, says equity markets like a medium rate, not too high, but not too low. So the question is whether rising prices will remain a while longer, whether they will settle at an acceptable level, or boil over.
Most economists agree that inflation will continue to creep up and is likely to breach the BoE’s 2pc target, but will stabilise before long. This is because many of the reasons underlying the increase are based on temporary factors, due to global economies emerging from lockdown. Production levels of goods were cut severely last year because of a lack of demand and social restrictions, as millions of people were forced to stay at home.
Now, however, production is being ramped up again, but not fast enough to prevent temporary shortages, which are pushing up prices. For instance, microchips used in cars and computers are currently in short supply. Similarly, oil and commodity prices fell last year as demand dropped, but the return to normal levels is stoking inflation.
Bounce back from lows of pandemic
Pent-up demand caused by Covid restrictions has also caused prices to spike, but the effect is likely to fall away within a few months.
Although most economists believe inflation is a temporary phenomenon, there is always a risk it could escalate.
Laith Khalaf, a financial analyst at wealth management platform AJ Bell, says that for the time being, the BoE regards consumer price increases as a natural bounce back from the lows of the pandemic in spring last year. But the economic recovery could prove to be a Trojan horse, smuggling inflation into the UK right under the nose of central bankers.
Central banks and governments around the world released trillions of pounds of spending in response to the pandemic. Therefore, there is always the risk that the money poured into the economy could lead to escalating prices.