Inflation is the increase in the price of goods and services over time. Known as the ‘silent killer‘ of investments, it can erode the value of your wealth because as inflation increases, the purchasing power decreases.
Buying the same goods or services costs more, or the same amount of money buys fewer goods and services.
In this guide, we’ll explore how inflation works, its effect on your investments and some strategies to mitigate its impact.
How is inflation measured?
One of the main ways of measuring inflation is the Consumer Price Index (CPI), which tracks the average change in prices for goods and services over a 12-month period. The Office for National Statistics (ONS) takes a “basket of goods”, including food and fuel, and measures the price of everyday items.
Interestingly, the items are changed to keep up to date with current shopping trends. So in 2024, vinyl records, air fryers and spray oil were added. Hand sanitiser, sofa beds and bakeware were taken out.
There is also the Producer Price Index (PPI) which measures the average change in selling prices received by domestic producers for their output.
Consider these three different types of inflation:
- Demand-Pull inflation – when demand for goods and services exceeds supply.
- Cost-Push inflation – when an increase in the costs of production, leads to higher prices for consumers.
- Built-In Inflation – when businesses and consumers expect prices to continue rising, perpetuating the cycle.
What’s the current rate of inflation?
Inflation decreased to 2.3% in the year up to April 2024, the lowest rate since September 2021. The sudden drop from 3.2% on 24 March follows a sharp decline in household energy bills and food costs.
When making decisions about interest rates, the Bank of England also considers core inflation, which doesn’t include the price of energy, food, alcohol and tobacco. This has remained higher than average at 3.5%
Link with interest rates
Increasing interest rates is intended to lower inflation. It is thought that if borrowing is made more expensive, people will have less money to spend and may choose to save more. This reduces the demand for goods and slows price rises. However, increasing borrowing costs can harm the economy by slowing down aggregate demand and GDP growth.
The Bank of England’s target for inflation is 2%. But even though inflation has hit the magic twos and fallen to 2.3 %, this was not as low as some economists predicted. Rising oil prices and talk of fuel shortages, combined with the ongoing geopolitical risks, keep the situation precarious. So, the BoE is expected to hold interest rates at 5.25% and not cut them until much later in the year.
Does inflation follow a pattern?
The challenge in accounting for inflation is that it doesn’t follow a steady path and is difficult to predict.
Over the last few years, inflation in the UK has experienced significant variation, averaging 2.83 percent from 1989 until 2024. It reached an all-time high of 11.10 percent in October of 2022 and a record low of -0.10 percent in April 2015.
Why are you investing?
You could have two main reasons for investing. You could be investing to grow your wealth, in which case beating inflation is imperative. Or you could be investing to preserve the wealth you’ve built up. In this scenario, it’s just as important to stay ahead of inflation so your money will hold its value and not be eroded.
The bottom line is the returns on investment should be at least as high as the inflation rate, otherwise, there’s little point.
Inflation’s impact
Inflation will have a different degree of impact on your investments depending on their type.
- If most of your investments are in cash or the cash equivalent, inflation will erode their purchasing power quickly. Saving accounts typically offer returns lower than the inflation rate, so you need to look for higher-yielding options.
- Fixed-term bonds are also particularly vulnerable, as when inflation rises, the fixed interest payments from bonds lose their purchasing power. By definition, because they’re fixed they can’t keep up. Bond prices also usually fall as interest rates rise.
- Equities can offer some protection against inflation as companies may raise prices to
pass costs onto consumers. However, inflation can squeeze profit margins if costs rise faster than revenues.
- Property values and rental income tend to rise with inflation. However, rising interest rates can also increase borrowing costs and impact property prices.
- Commodities like gold, silver and oil often perform well during inflationary periods because their prices tend to rise with inflation.
Strategies to Mitigate Inflation Risk
Inflation is inevitable in the economic cycle, but it doesn’t have to erode your investment returns.
Let’s consider the following strategies to mitigate the impact:
- Diversify your investments across various asset classes, sectors and geographies to reduce risk and increase the potential for returns that will outpace inflation.
- Consider UK Index-linked Gilts or other inflation-linked bonds. These adjust their interest payments based on inflation and safeguard the purchasing power of your fixed-income investments. Also, choose shorter-duration bonds that are less sensitive to interest rate changes.
- Invest in shares in companies with a history of paying increasing dividends, which can provide a steady cash flow and partially offset the effect of inflation.
- Allocate a portion of your portfolio to growth sectors likely to benefit from economic expansion, such as energy, materials and consumer staples.
- Explore tangible assets such as property and commodities that tend to hold their value and appreciate during inflationary periods.
- Review and rebalance your portfolio regularly to ensure it stays aligned with your investment goals and risk tolerance in light of inflationary trends.
By understanding how inflation impacts your different types of investments, you can implement effective methods to protect and grow your wealth.
This may mean having a mix of ‘higher-risk, higher-return’ assets in your portfolio to generate sufficient inflation-beating returns. But remember the golden rule—only take on the level of risk you are comfortable with.
Please do not hesitate to contact us if you would like to ensure your investments are well-positioned regarding inflation.
The value of investments can fall as well as rise and is not guaranteed. Past performance is not a guide to future performance.
The information contained within this article is based on our understanding of legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change.
The content in this article was correct on 02/07/2024.
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