The devastating threat that everyone is ignoring

published 23 March 2011

"I know we're all meant to be in this together. I know I have to cut back...but it just doesn't seem fair!"

A grizzled looking face stared at the BBC reporter. "To be honest if inflation keeps going up, I don't know if I'll be able to drive to work next month!"

I had just flicked on the box this morning to catch the news. And a very weary looking parent was relating his financial concerns to an enthusiastic BBC news-team. You could see on the reporter's face that this was just what the BBC had come for. Inflation has hit 4.4%. And what people really need is an opportunity to have a good, therapeutic moan about soaring petrol and food prices.

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But this completely misses the point.

In fact, there is a far more disturbing story here that the BBC has failed to pick up. It's the real reason we've seen inflation jump to 4.4%

And if we don't prepare for this threat soon, it could be a lot more devastating than not being able to put petrol in the car to go work...

This isn't inflation, it's tax!

The chart below is a very telling one. It shows the Consumer Price Index (CPI, the thick black line) - and it's up from around 3% a year ago to 4.4% today. And that means everyone can lament its destructive effect onsavings and real incomes.

But what's more interesting is the thin black line that depicts inflation excluding tax. It's gone down from around 4.5% last year to under 3%. That's right - inflation has actually fallen over the last year!

Source: Office of National Statistics

No, inflation isn't your problem. It's Mister Osborne's tax take that's really hurting - from VAT to fuel duty and alcohol duty.

Sure,oil prices andcommodities shooting through the roof are starting to raise underlying inflation. But this is all just another tax anyway - one that gets paid to the oil, mining and farming industries (that's why I keep saying we should have exposure to all of them).

The real story here is about George Osborne. How he needs your cash to balance the books.

But here's the disturbing part: he can't do it. He can't balance the books. And this is what's really scary...

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The sums don't stack up!

Yesterday, as well as figures on inflation, we were treated to the public sector borrowing situation. And what a shocker... the Government borrowed over £11.8bn in February just to make ends meet. That's up nearly 25% on last year.

Let me just emphasise that. Despite all the juicy new taxes that they've hit us with, the government's deficit for February was up... and by a quarter!

Forecasters had anticipated a fall (as well they might), after all, the government is supposed to be cutting the bills as well as stiffing us for more tax.

But the truth is we're on a very slippery slope. I've said before that I believe we are in a deflationary environment. The economy is more sickly than most people realise. And that's why, regardless of headline inflation, rates won't be hiked any time soon...

Mervyn King knows a serious hike will only hit consumers even harder. That's why he's imploring the rest of the committee to sit tight on rates. Sure rates are going to go up - but by what? A couple of quarter percent rises by the year end?

Bank rates will still be at 1%...

Since I started writing the Right Side (over a year ago now) I've been saying that rates are going to stay lower and for longer than anyone expects. And I'm sticking to my guns.

We're stuck in a stagnant economy. And you might as well get used to it...

Here's my advice

We need to stop moaning about inflation, not least because it really isn't as bad as you're told. There are three things that I would advise you do to ride this out.

First, make sure your equity portfolio is well diversified away from the UK economy.

Recently I've extolled the virtues of investing in Russia. And for international diversification, why not try theFTSE 100 - yes that's not a mistake - the FTSE is like a globally diversified fund with around two thirds of earnings come from abroad.

Second. Get exposure to commodities. You can achieve that through commodity based ETFs, or my favourite commodities fund. Or you can simply buy resource related stocks on the stock market. And that should be pretty easy when you consider that about a third of the FTSE 100 is energy and resource related.

Third, don't worry about sitting on a bit of cash. I know it's not a popular bit of advice, but I'm sticking with it. Putting your cash into a retail bond - you can earn around 4% to 5% - put that in a tax efficient wrapper like a SIPP, orISA and you'll not be far off keeping up with inflation. I'll be writing to you soon about how you can get exposure to these sorts of bonds - they really could be useful if you're stuck for a home for your cash.

Don't expect the Bank of England to change tack on rates... you could be waiting a long time.

This article was first published in the freeinvestment email The Right side. Sign up to The Right Side here.

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Commissions, fees and other charges can reduce returns from investments. Profits from share dealing are a form of income and subject to taxation. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.

He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.

Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.