Inflation is waking upMost of the major central banks are predicting rises in inflation. Price pressure was already beginning to build in 2016 as the world economy showed signs of improvement. Now the policies of a new Trump administration – lower taxes and increased government spending – could increase that pressure. The expectation among economists in January was for G20 inflation to rise from 1.1% in 2016 to 1.8% in 2017, with more marked increases in Western economies, according to OECD data.
Why is inflation so important for investors?Inflation erodes the value of savings over time. The higher the level of inflation, the faster the spending power of savings will fall. The chart below shows how the real value of money effectively shrinks over 20 years, offering scenarios of 1% and 5%. After 10 years of 5% inflation, £100 has shrunk to around £60. Even with a low rate of 1%, the real value would fall to £90. This underlines why investors strive so hard to achieve a return greater than the level of inflation – the “real return” that actually helps a portfolio to grow. If inflation rises, investors are more inclined to move away from cash deposits and toward certain investments that, historically, have offered returns that outpace inflation. A repeat of this success is not guaranteed.
Where are we at today?Inflation has been exceptionally low in developed world economies since the financial crisis of 2008-09. Some countries have even endured bouts of deflation. This was despite unconventional intervention by central banks with the electronic creation of money through quantitative easing (QE), aimed at kick-starting strong economies.
In the past few months, inflation has picked up significantly, as shown by the blue line in the chart below. Headline inflation rates are calculated using the consumer prices index (CPI). This index includes energy prices, such as petrol and heating oil. Stripping out volatile energy and food prices adds a different perspective. This “core inflation” has been more stable (the orange line) and has not, so far, felt the knock-on effects of recent rising energy prices. The art for economists in forecasting inflation is to judge the supply and demand balances in the economy. They look at the health of the jobs market and wage growth and at the price of goods leaving factory gates, which can offer early warnings of rising inflation. It is also taken into account that the fear of inflation itself can stoke inflationary pressures, as workers see prices rising and demand higher wages. Surveys that show inflation expectations are closely watched.