Studies have shown that of all the problems facing society and economies today—like climate change, geopolitical strife, social inequality, and crime—inflation is the one people find the most worrying.
What is inflation and why is it such a problem?
A simple explanation of inflation is that it is a sustained increase in prices. The official UK inflation figure released by the Office of National Statistics (ONS) every month is the Consumer Price Index (CPI), which shows the average price increase in a basket of over 700 goods versus this time last year. Other inflation metrics such as the Retail Prince Index (RPI) are less recognised internationally.
Much of the world spent 2022 contending with inflation rates at or near double-digits, meaning prices were increasing rapidly over a very short timeframe. High inflation dents the purchasing power of your money. It means that, over time, the same amount of money buys fewer goods and services. It can also erode the value of your savings and create uncertainty about the future.
Following the global bounce-back from the Covid-19 pandemic, several factors contributed to an uptick in inflation. To counteract the economic downturn caused by lengthy lockdowns, governments implemented programmes meant to stimulate the economy, like sending out cheques to taxpayers and extending unemployment benefits. Many industries contended with supply chain disruptions as employees fell ill or stayed at home, which meant supply couldn’t keep up with demand—so prices rose.
It fell to the central banks to sort out the problem of soaring prices, and the most direct way to do that is by raising interest rates to reduce borrowing and spending, thus cooling an overheating economy and, hopefully, curbing inflation. They did so in earnest—the Bank of England (BoE), for one, has hiked rates 13 times since December 2021. But UK inflation hasn’t quite fallen like it has in the US and eurozone. The possible reasons why UK inflation is stickier than in other regions are complex and sometimes controversial. They include the disruptive impact of Brexit on labour supply and overseas investment; the government and the BoE’s stimulative policy responses to Covid, which put more money into circulation; and finally, the energy and agricultural shocks from the Ukraine war taking longer to percolate through the UK economy. The reasons may be complex, but the result is not: consumers now face the twin challenges of both high inflation and high interest rates.
Inflation in and of itself is neither good nor bad
Low, positive and stable inflation is the economic ideal to keep buyers buying and economies growing; but unfortunately, things are out of whack. And excessively high inflation keeps things unbalanced: people demand heftier wages to contend with higher costs, which in turn pushes inflation higher. Companies are loathe to make substantial investments (for example, investing in raw materials for manufacturing, or hiring more staff), as it’s too hard to predict the end cost of that investment. Very low inflation comes with its own set of problems: if falling prices become the expectation, consumers are less likely to go out and spend, assuming that waiting a while will reward them with lower-priced goods.
What happens if we can’t bring inflation down?
A recurring study by Ipsos Public Affairs, which regularly surveys more than 20,000 people from 29 countries, found that rising inflation was cited as the world’s biggest worry for the fifteenth month in a row, surpassing perennial issues like global warming, poverty or the threat of another pandemic. This may be because inflation has an exacerbating effect on many of these problems:
Social inequality was a top answer of the study’s respondents, and one that inflation is apt to exaggerate: if the current inflationary environment lasts, lower earners will need to spend more on essentials like food, utilities, and their mortgages. Furthermore, taxes and government funding will be diverted from public services. Meanwhile, more affluent members of society might make less dramatic changes like cutting back on discretionary spending and could even earn more from their investments.
Battling climate change is another social issue that won’t be given the attention it commands, as stalling it will require massive investment from both the public and private sectors; funding and donations will be harder to encourage if inflation is high and variable because interest rates – the cost of that investment – will be high, and more generally, businesses and households will have less visibility over (and confidence in) the long-run economic outlook required to make such a lengthy commitment.
Ageing societies, like those of Japan and Europe, may need to borrow to fund the pensions and healthcare needs of their increasingly elderly populations. Higher interest rates, as a result of high inflation, will increase the cost of that borrowing.
How can we fix the problem?
In the UK, the responsibility lies with the BoE. And the good news is, we expect it to succeed. We’ve seen evidence of that internationally, such as in the US, where the Federal Reserve has raised interest rates aggressively and inflation has fallen from over 9% to 4% in the past 12 months. The European Central Bank has also brought inflation down significantly, to 6.1% from its October peak of 10.6%.
Things aren’t moving as quickly in the UK. In May, core inflation (which excludes food and energy prices) rose to a 31-year high—which suggests rate rises may well continue. The BoE will now have to decide how much pain it believes the economy can or must endure to bring inflation down. Many experts believe we may ‘need’ a recession, as a prolonged slowdown will cool both job markets and demand, which would discourage spending. The government can help by resisting stimulus activities like unfunded tax cuts.
Can lower inflation rates overseas help?
In a word, yes. As mentioned, some of our developed-market peers have thus far been more successful in their fight against inflation, and that will help bring down demand for global goods like oil and mining products. But the wildcard for the UK is our independent currency. If the value of sterling decreases, imports will become pricier in local-currency terms, which could stoke inflation. Larger economies with more widely used currencies (like the US dollar or the euro) aren’t as susceptible to this challenge.
How do our portfolios measure up against inflation?
The common thread uniting our portfolios is a diversified, actively managed approach to investing. What this means is that our funds are, by construction, less vulnerable to any one economic risk, including the fallout of excessively high inflation. Our active approach gives us flexibility: when needed, we can adjust our holdings to protect portfolios from the knock-on effects of rising inflation, or even take advantage of any opportunities that arise as the economic landscape shifts.
With inflation as high as it is, we’re facing an issue we haven’t seen for decades, which could leave investors feeling ill-prepared. While this is understandable given its social impact, long-term investing via diversified portfolios that can adapt to inflationary pressure, remains an effective way to protect the value of savings.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable, but are not guaranteed as to accuracy or completeness by atomos. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and is not guaranteed. Investors may not get back the original amount invested.