Inflation in the US, UK and elsewhere has not been this high in decades. What does this mean for investors?
US consumers are paying 8.5% more for consumer staples today than they were a year ago. This is the highest rate of price increase in more than 40 years.
In the UK, the year-on-year price increase is 6.2% – again the highest rate in decades.
Inflation is being felt all over the world as the prices of food, fuel, electricity and many other items that make up our routine purchases rise rapidly. This marks a distinct shift. In recent memory, inflation in most developed economies has been low.
What has changed and what does it mean for investors?
What is Inflation?
Inflation describes a change in prices. Where official consumer inflation statistics are provided on a national basis (such as the figures for the US or UK above), they are usually calculated by governments. They calculate price changes by tracking a basket of commonly purchased items. Examples include food and drink, clothing, footwear, transport and energy costs.
There are other types of inflation measures. Producer price inflation, for example, tracks the prices manufacturers pay for the raw materials needed to make their products. There are also measures of house price inflation or energy inflation.
If the inflation rate is reported at 5% year-over-year, that means prices in general are 5% higher than they were at this time last year.
From 5p to 50p in five decades: real rise in the price of a pint of milk
In January 1971 the average price of a pint of milk in the UK was just five pence. It remained at about this level until 1975, after which it gradually rose to just under 40 pence in the 1990s. The biggest increases have come recently. In April 2021 a pint of milk cost 42p. In March 2022, this reached 50p: a 19% increase in less than a year.
What causes inflation?
Inflation has several potential causes. Economists speak of two main types: “cost push” or “demand pull”. If the costs of producing goods and services increase, consumers are faced with an increase in the prices of the finished products: this is “cost pressure”.
But prices can also rise when there is more demand for something than there is capacity to supply: this is “demand pull”.
Today’s inflation is driven primarily by cost surges. Energy is a component of most goods and services, and when its price rises, as it is now, producers will have to pass on the cost. The disruption of supply in China and elsewhere, caused by the Covid pandemic, had a similar effect. The supply of components, consumer electronics and auto parts has fallen, driving up their prices.
Why is too much inflation seen as a problem?
The most obvious danger of inflation is that if prices rise faster than incomes, people can afford to buy fewer goods and services. This can mean a lower standard of living.
In practice, the negative effects of inflation are more subtle, affecting different groups in different ways and having a wider destabilizing effect on societies.
These are just some of the negative effects of inflation:
- Inflation is hardest for people on fixed incomes such as retirees
- It destroys the value of money and discourages saving
- This can lead workers to demand higher wages, creating a “wage-price spiral” of further inflation
- It can increase the cost of borrowing, adding to financial pressures on households and businesses
- Because future costs are difficult to predict, this can deter companies from investing
- It can reduce the value of a currency against other currencies, making imports more expensive
- This can increase government costs and borrowing, as more provisions may need to be made for pensions and other expenses
- In the worst case, countries suffering from high inflation must abandon their local currency and adopt the currency of a more stable nation. This happened in Zimbabwe after hyperinflation in 2008 forced the country to use the US dollar.
Hurting savers: how the value of cash is eroding
Even low inflation eats away at the purchasing power of cash. In the 21 years since 2000, UK inflation has averaged 2.8%, according to the Bank of England. This is a small number compared to the current inflation rate of over 6%. But £10,000 put in a box in 2000 would have been reduced to just £4,639 by the end of 2021.
What is the relationship between interest rates and inflation?
Inflation and interest rates are closely linked. Indeed, interest rates are the main tool used by the central banks of countries (such as the US Federal Reserve or the Bank of England in the UK) to control inflation.
How it works?
Most central banks are responsible for keeping inflation below an agreed level (say 2%). When inflation rises, central banks raise interest rates as a way to control it.
Higher interest rates lead to higher borrowing costs and, therefore, fewer expenses. This can curb inflation. The reverse is also true: if inflation is low and the economy is growing too slowly, central banks could cut interest rates to further stimulate borrowing and spending.
If it’s inflation, what about deflation and stagflation?
Inflation describes a general rise in prices. Deflation is the opposite: it describes a period when prices fall.
As with inflation, too much deflation is undesirable. Falling prices can lead to the postponement of spending and investment, removing demand from the economy and weakening growth.
Stagflation describes an unusual set of circumstances in which prices are high or rising, but at the same time economic growth is low or falling. This is what many economies could face in 2022.
The lessons of history on inflation
There are parallels between events today and those of the 1970s. Back then, oil shocks drove up the price of oil, which triggered higher inflation. In the United States, inflation reached 14.8% in 1979.**
In the 1970s, central banks were slow to act, in part because raising interest rates was not a popular decision. Instead, they hoped that the mere fact that goods and services were becoming more expensive would keep people from spending.
In fact, the opposite happened. Consumers spent more because they expected prices to continue to rise, which only pushed prices up further.
Finally, policymakers turned to interest rates. In the United States, for example, the new Chairman of the Federal Reserve, Paul Volker, raised interest rates from 10% in 1979 to almost 18% in 1980.
This time around, policymakers are much more willing to use interest rates to control inflation, not least because central banks are now independent. Our economists at Schroders believe that we are unlikely to see the same levels of runaway inflation as in the 1970s and 1980s, but that we will have to go through a period of painful adjustment that will include higher unemployment and economic growth. slower. in order to return to a more stable inflation situation.
Inflation Snapshots: Double Digit Years
You spent £1000 in 1970. How much would you have to spend ten years later (1980) to buy the same amount of goods? £3,608 (13.7%)
You spent £1000 in 1975. How much would you have to spend five years later (1980) to buy the same amount of goods? £1,967 (14.4%)
You spent £1000 in 1979. How much would you have to spend a year later (1980) to buy the same amount of goods? £1,180 (18%)
Source: Bank of England
Practical Ways for Investors to Limit the Harm of Inflation
Consumers can hedge against rising prices by fixing certain expenses, such as energy bills, loans and mortgages.
But what about their savings and investments?
As our examples show, cash performs poorly when prices rise.
Company stocks tend to hold their value better than cash, but their ability to resist inflation varies depending on a range of factors.
Recent research from Schroders has looked at history to see how stocks in certain sectors have performed during periods of stagflation – such as we may face in 2022 – when inflation is above average, but when the economic growth slows. He concluded that:
- Stocks of defensive companies (those that sell essential products and services, such as electricity or basic household goods) tend to hold up better
- The best performing equity sectors during periods of stagflation have been Utilities, Consumer Staples and Real Estate (1995 to December 2021. Source: Schroders Economics and Strategic Research Unit).
Diversification is another key defense in times of inflation, with a well-managed portfolio being exposed to a range of asset classes. So, alongside your holdings of company stocks (as above), you can gain exposure to commodities, such as gold, real estate, and other alternative assets, including private assets ( investments not listed on public markets).
Some investments, such as inflation-linked bonds, are explicitly designed to pay with inflation. However, the demand for these investments increases during periods of inflation and can therefore drive up their prices.
Originally posted by Jo Marshall, Investment Writer, Schroders