Your best shot at inflation-beating investment income

Today's issue will likely be divisive. Some readers will dismiss what I'm saying out of hand and I'm prepared for some animated discussion on the comments page.

That's OK. Debate is good. A clash of opinions is what makes a market, after all.

Here's what's on my mind. Then you can tell me what you think.

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Lately, there's been a lot of scare mongering, moaning and bleating about inflation. Things like "Inflation is on its way to hyperinflation", "I've been robbed by the government" and the classic "Quantitative easing is counterfeiting"

Frankly, I'm fed up with all that moaning. Let's take a close look at what's really going on. And rather than complaining about getting robbed' let's first understand the situation so that we can learn to live with what's thrown at us.

Mervyn King's brilliant double bluff

You probably saw the news headlines yesterday. UK consumer price index (CPI) inflation has now topped 5.2%.

To be honest, I'm a little surprised. I've long held the view that we'd see some deflationary forces coming into play this year. That hasn't happened.

I'll admit inflation is a devilishly difficult thing to forecast. There are just so many factors at play. Sure, loose monetary policy and the low pound stirred up inflation through higher import costs. But there's more to it than that.

First, there's the seemingly insatiable demand for commodities from the East. In fact, if oil stays in its current range, then 2011 will be the most expensive year ever for energy. Then there's the rising labour costs coming out of the East too, pushing up export prices. And to top it all off, weak Western currencies add another layer of cost to our imports.

But probably the biggest unknown and unquantifiable factor behind inflation is investor and consumer psychology.

Now here's where some Right Siders are going to disagree with me. But hear me out.

I'd argue that the central bankers played an absolute blinder with investor and consumer psychology. And in doing so, they've turned around a devastating situation.

Cast your mind back to 2008. You'll remember that investors and consumers thought the world was about to drop off the edge of a cliff. Nobody was buying. Nobody was investing. Economies ground to a halt.

All of a sudden, central bankers were faced with tanking financial markets, deflating GDP and deflating prices. They had to force a change in sentiment.

And they did!

Bank policy rates were slashed. Money was pumped into the markets by buying government bonds with freshly minted cash. They claimed this was in an effort to bring down interest rates and get money flowing through the economy again.

Fine but to turn the economy around they needed more.

And to do this, they played a brilliant double-bluff: central banks insisted they didn't want to risk inflation. They made it clear that they wanted a strong dollar/pound/whatever. But in reality, this rhetoric only convinced people we'd get the opposite.

What do you do if you think your cash is going to be worth less in the future? You go out and spend it now. And that has a positive effect on inflation or at least it helps stop outright deflation.

Nobody can quantify the psychological effect inflation expectations had and are having. But my guess is it's the main reason we're not suffering deflation today.

Why central banks saved us from a far worse fate

Just think about exactly what life was like during the worst of the crisis in 2008 and early 2009. The economy was going backwards. Nearly everyone was facing losses.

At the depths of the crisis, investments were stuck in a nasty downtrend. Pensions and general stock market savings were getting mauled. But just look at the recovery we've had and central bank actions have had a lot to do with it. Sure there's been some inflation induced losses on cash but just look at how the rest of your portfolio has recovered.

People moan about all those 'profligate debtors' that have been let off. But let's just consider what would have happened if businesses and individuals were pushed to the brink of collapse.

The economy would have collapsed too. Paper assets (save cash) would have continued their depression-like descent. Would that have been a worthwhile sacrifice to get a few extra points of interest on cash?

And so what if the Government is attempting to inflate its way out of debt'? Let us just remember whose debt this is. It's the debt of the nation. If it wasn't being eroded by inflation, then we'd have to pay the difference through tax. And that would be bound to hit wealth holders hardest I mean you can't tax people that haven't got any money!

Of course, there are winners and losers from the whole inflation/deflation situation. I don't deny that some people are hurting.

But it strikes me that a little bit of inflation is a worthwhile sacrifice for keeping us from a deflationary debt spiral. For all those that moan about how inflation has hit them, let us just remember what the alternative might have been.

This isn't the time for moaning. We have higher inflation than any of us would like, let's deal with it. I'm working on some new ideas for protecting and growing your wealth in this climate. Keep reading The Right Side in the weeks ahead to hear about those.

Meantime, to start with, own some gold. Although gold doesn't pay an income, it's the best protection we've got against the central bankers losing control of their psychological games. If their bluff works too well, then we really will have an inflation problem and gold's credentials as a store of value will be invaluable.

Start using stocks to beat inflation

To get your money earning an income that stands a fighting chance of beating inflation, consider good quality dividend paying stocks. New research out from Capita this week said UK dividends are at three-year highs up 16.9% on 2010.

Capita Registrar's CEO, Charles Cryer, said: "Dividends are growing faster than we expected as UK firms shrug off the worst stock market conditions since 2008 and continue to increase payouts to shareholders.

"In real terms they still have some way to go to top previous highs, but investors will be grateful that at least one asset class is providing a solid, inflation-proof income."

My colleague Stephen Bland says big companies are best placed to do this for you. He's built an income strategy around them.

And I'll be back with some more ideas soon.

This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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