Protect your wealth from the miseries of stagflation

The economic outlook for the UK is taking a distinctly unpleasant turn.

On the one hand, prices are rising too rapidly for comfort. Fuel prices in particular are becoming a sticking point. And consumer price index (CPI) inflation at 3.7% is getting to the point where the Bank of England will have difficulty pretending that it's a temporary blip.

On the other hand, economic growth is slowing it may even have come to a standstill in the fourth quarter of 2010.

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It all adds up to one thing stagflation...

Inflation figures have split analysts' opinions

Last week's inflation figures gave the markets a nasty surprise. Investors are now predicting that we'll see three interest rate rises from the Bank of England by January 2012. This has analysts' opinions split across the board.

Roger Bootle of Capital Economics is probably among the most prominent of those who reckon the Bank shouldn't give in to pressure to hike rates. He notes in The Telegraph that the Bank was quite right to hold fire in 2008. "CPI inflation peaked at 5.2%, reflecting a surge in the price of oil and food and the start of sterling's depreciation instead of hiking interest rates, the MPC cut them, amid signs that economic growth had slowed considerably."

It's true. But I'm also not sure that it's a valid comparison. In 2008, we were heading for a crisis. Northern Rock had been nationalised. The bank may not have been significant on a global basis, but its collapse shattered British savers' confidence. Meanwhile, the US housing market was collapsing. The MPC may not have seen Lehman Brothers coming, but times were precarious the last thing anyone expected or wanted was an interest rate hike.

The atmosphere has changed now. The UK economy is certainly still wobbly. But few people expect another collapse in the mould of Lehman. A crash in China is perhaps the most obvious comparable risk for 2011, but I don't think the average UK consumer is scared the way they were scared following the queues outside Northern Rock.

Now inflation seems like a genuine ongoing threat. People aren't scared about banks going under and taking their savings with them. They're starting to worry more about their savings being eaten away by inflation, and their standard of living deteriorating under the weight of rising petrol prices.

The Bank of England is right to be woried about economic growth

Of course, the trouble is that the Bank is right to be worried about economic growth. Consumers are already being squeezed. Rising costs for essentials hit their spending power. If the Bank decides to jack up rates as well, it's only going to hit consumers' pockets even harder.

And as Liam Halligan pointed out in The Sunday Telegraph, there's a chance that we might learn this week that the UK economy "didn't grow at all between October and December". Some of that can be blamed on the particularly nasty winter weather, but it's still hardly good news.

So what's going to happen? For now, the Bank seems unlikely to do anything too rash. As we've noted already, the key thing to watch is the pace of wage hikes. As long as pay remains broadly under control, then the Bank can support its view that there's enough 'spare capacity' in the economy to keep inflation under wraps.

Of course, if we continue to get high commodity price inflation along with stagnant wages, then that just increases the danger that the economy will slow. That's one reason why a slowdown in China could be just what we need, as we've mentioned already: What a China slump would mean for your portfolio. This would at least take some pressure off prices, and in turn, the UK consumer. But being reliant entirely on economic conditions in a country on the other side of the world is not a comfortable position to be in.

How to protect your wealth

What can you do about it? Well regardless of what happens with interest rates, you're unlikely particularly if you're a higher-rate taxpayer to be earning a real return on your savings in the near future. But if you can't afford to take any risks with your money then you'll just have to put up with it and get the best account you can.

As far as your investments go, the threat of stagflation is another reason why we still like big, blue-chip, dividend-paying stocks. We're talking about the kind of companies who produce goods that consumers buy almost regardless of the economic backdrop companies with pricing power, so they can protect their margins when costs go up.

We've been tipping these for a while now and you can read our Roundtable experts' latest views on inflation in the next issue of MoneyWeek out on Friday. (If you're not already a subscriber, subscribe to MoneyWeek magazine.) And to help you keep an eye on the latest state of play with inflation, we've put together a range of UK inflation indicators which we'll be updating regularly.

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