Inflation in the Nation

The Central Bank in the UK, the Bank of England (BoE), aims to keep inflation at a target level of 2%. This target helps prices rise slowly and predictably, allowing people and businesses to plan their spending. If inflation is too low, it can lead to deflation, where prices fall over time. While cheaper prices might sound appealing, deflation can harm the economy by reducing spending and business sales as people delay spending in the expectation of prices becoming cheaper. On the other hand, if inflation is too high, then the value of money decreases over time meaning people can buy less with the same amount of money. Therefore, the aim is the goldilocks “just right” scenario and for prices to rise in a gradual and predictable way, so people can plan for the future with more certainty.

UK inflation rates have varied significantly over the past few years. The question some people are asking is whether the 2% target is still relevant today. Looking back from mid-2012 to mid-2021, UK inflation was persistently below 2.5%. During this time in the UK, both the government and private sector were paying off debts, leading to less borrowing, spending, and investment. Productivity and economic growth were also weak and despite very low interest rates of around 0.75% or less, there wasn't enough demand to boost the economy. This led to a period of low and weak inflation raising questions about whether the 2% inflation target was achievable and if the BoE's monetary policy tools (methods by which it can control the economy and keep inflation stable) were effective.

However, since 2022 the private sector is in better financial shape, the government is planning to spend more to boost the economy, and energy costs are more variable and higher in Europe. Overall, these factors tipped inflation pressures upward relative to the previous decade. Looking forwards, the real unknown is the impact of potential widespread adoption of productivity-enhancing Artificial Intelligence (AI) which could see inflation fall due to fewer jobs, higher profit margins for companies, and lower production costs. Our view is that it is likely that inflation will be somewhat higher in the next decade than in the last decade, post the Global Financial Crisis when it was persistently below 2.5%.

Although our comments are focused on the UK, we can draw parallels with other global developed market economies, such as the US which also has a 2% target inflation rate. We have just experienced a period, for the first time in decades, where the pain of unexpected inflation has been felt across global economies. In our view, this makes delivering stable, low but positive inflation even more of a policy priority from both a political and economic perspective suggesting 2% is a sensible target to retain in these developed economies.

Changes to inflation, both realised and changes to expectations, can have significant effects on asset performance and returns. To manage this risk, we turn to a key pillar of our portfolio construction process: diversification. As different assets have different sensitivities to inflation, we look to have exposure to a mix of assets with positive and negative sensitivities to balance a portfolio with an aim to minimise where possible the impact of unexpected changes to inflation rates and expectations.

The Noise

• The UK economy unexpectedly expanded 1.5% year on year, in December 2024. This GDP figure came in well above market expectations of 1% and it is the highest economic growth in over two years. This was driven by a 0.4% gain in the services sector, a 0.7% growth in manufacturing, and a 1.5% growth in mining and quarrying. The growth is positive news for the Labour government and for Chancellor Rachel Reeves who has been under pressure to deliver improved growth. The market reacted positively to this data, with the pound strengthening by 0.4% against the dollar on Thursday morning.
• US inflation unexpectedly rose to 3% in January, compared to 2.9% in December. This figure came in 0.1% above market expectations, which had previously predicted inflation would plateau at December’s level.
• This marks the continuation of incremental increases in the annual inflation rate which has steadily risen since reaching an annual low of 2.4% in September 2024. Motor vehicle insurance and recreation were the main sectors which contributed to this price acceleration which rose by 11.8% and 1.6% respectively. These figures were both 0.5% higher than the previous month’s measurement. This unexpected increase in inflation reinforces the Federal Reserve’s cautious rate cut outlook for 2025. The market has now priced in a c.50% likelihood of a rate cut by mid-2025, according to Reuters.
• The price of coffee has risen by approximately c.25% since the start of 2025, making your daily cup a bit more expensive. While we might think of coffee as just a hot drink, it’s also a commodity (a basic good traded on markets with prices fluctuating based on supply and demand). One major factor driving costs higher is climate change, which is negatively affecting coffee production. A recent study shows that arabica beans, one of the primary coffee beans we use, are highly sensitive to temperature changes and will face supply shortages as the climate shifts. With lower supply and rising demand, coffee prices are expected to climb—so don’t be surprised if your next visit to the coffee shop costs a little (or a lot) more!