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Is higher inflation coming?
With Consumer Price Index (CPI) inflation running below 3% since March 2012 and at or below the Bank of England’s inflation target of 2% since November 2018, inflation has not been at the top of many of our clients’ lists of concerns over recent years. However, in recent months as the long-term impact of COVID-19 has been debated, commentators have raised the possibility of higher inflation in future.
So why might we expect higher inflation in the coming years? Firstly, in the short term, we could see a spike in inflation when life returns to ‘normal’ and households start to spend the money they have accumulated during lockdown. Additionally, increased import costs (or substituting imports for more expensive British goods) as a result of Brexit could be inflationary.
The global outlook
On a more global level, there is also a view that the levels of quantitative easing (a tool central banks use to inject money into the economy by ‘creating’ money) we have seen will surely lead to higher levels of inflation and central banks have indicated they are happy to see above target inflation. This could suit governments as they potentially look to use inflation to erode the additional debt they have taken on funding their response to the coronavirus pandemic.
"Central banks have indicated they are happy to see above target inflation"
Given the above, a concern is that if higher inflation does arrive, central banks may be reluctant to use interest rates as a tool to control this given the potentially devastating effect increasing interest rates could have on indebted companies and households. Indeed, central banks have indicated they will start to unwind QE before increasing interest rates.
The other side of the argument is that low inflation will continue due to ‘secular stagnation’ (too much saving and too little investment within the economy) and the potentially long-term increase in unemployment that will follow the end of the furlough scheme later in the year.
What can you do to protect your finances?
- Have a sound financial plan
- Use cashflow modelling
- Incorporate your state pension
So, if you are concerned about inflation potentially increasing in future, what can you do to protect your finances? We believe to navigate these uncertain times, having a sound financial plan in place is crucial and the importance of this has been highlighted by the announcement in the Budget on 3 March that tax allowances are being frozen until April 2026, which will magnify the effects of inflation over the next five years. We use a cashflow modelling system which essentially builds financial plans for our clients, and incorporating an appropriate inflation assumption is an important part of this.
Every plan will include an appropriate amount in cash and though this will be losing money in real terms when interest rates are lower than inflation, it is essential to have liquidity. The importance of this was highlighted during the market falls in February and March last year, as selling down from invested assets at an inopportune time can have a significant negative effect on the long-term financial plan. We use Savings Champion’s cash research, independent savings experts, to ensure our clients get the best rates possible for any cash held within their plan.
As part of the financial plan, we would also incorporate the state pension. Given the ‘triple lock’ guarantee that currently ensures the state pension increases by the higher of average earnings, CPI inflation or 2.5% p.a., this is currently increasing faster than inflation, but there has been speculation that this ‘triple lock’ guarantee could be under threat as the government finds ways to pay for their response to coronavirus.
How to invest to beat inflation
For funds that are in excess of the emergency cash reserve in the financial plan, there are a number of options. For example, for pension fund, an annuity with inflation protection could be considered if inflation is a concern, but a 65 year old could expect to sacrifice around half the initial annual income amount when purchasing an annuity with RPI indexation compared to a level annuity (that pays the same level of income for life).
However, if funds are to be invested, one or more diversified portfolios could be considered taking an appropriate amount of investment risk, with the aim of achieving a return above inflation over the long-term. The level of risk within the portfolios which would take into account the time period within which the funds would be required and the investor’s ‘tolerance’ to risk, i.e. their ability to withstand the bumps along the road as their financial plan develops over time.
In summary, there are conflicting views on the impact inflation will have over the coming years and we believe having a sound financial plan in place which is reviewed regularly is the best way to navigate the uncertain times ahead.
If you would like to talk to us about your financial planning why not arrange a free consultation today? We have advisers who can help with cashflow modelling and investments.
Please note: The Financial Conduct Authority (FCA) does not regulate cash flow planning.