Inflation: should you worry a lot or a little?

At 2.1%, inflation doesn’t seem particularly high. But don’t dismiss those numbers, says Merryn Somerset Webb. It’s time to start getting worried.

Is 2.1% a lot or a little? A big number or small number? It depends how you look at it. I imagine that a lot of people looked at last week’s UK inflation numbers and wondered what on earth all the fuss was about.

The Bank of England guessed that the consumer price index for May would come in at 1.8%; it was actually 2.1%. The difference is tiny –  wat’s 0.3 percentage points here or there? And anyway, if prices are rising at 2.1% a year, is that really a big deal? Particularly when it is the job of the Bank of England to aim for 2%; shouldn’t we be thinking more “well done” than “run for the hills”?

Now imagine that the 2% is not inflation but a wealth tax. Henceforth you will be charged 2% of all the cash you have on deposit, simply for the privilege of having it at all. In five years you will lose going on 10% of your money (every £100 will have turned into £90.40). In ten years, some 20% will be gone (£81.70). Make that 3% and you’ll be down 27% over the decade. Suddenly 2% is a big number.

Back in the old days – the ones younger readers may not even remember – interest rates were generally higher than inflation. So if you had money in the bank, a bit of oomph in the index wasn’t a big deal for your purchasing power.

That’s not the case any more. Check your bank account; it may well be paying you no interest at all. If it is, the rate is most likely to be 0.1%. Look around, be prepared to do some admin and you should be able to get 0.4%. That might have felt OK back in November when the CPI was 0.3% (you were just about evens on the deal) but now, your future gets a little worse every day.

Central bankers aren’t worried about inflation...

So should you worry about this a lot or a little? The central bankers say a little, if at all. They say it is transient. Of course there is inflation: the mixture of saved cash and intense boredom produced by pandemic lockdown and bailout policies has obviously spawned an orgy of consumption – one that has met lockdown supply chain tensions and so bumped up prices along the way.

Note that the main price pressures come from the sectors you’d expect when low-level anxiety flips to exuberance: clothing, recreation and hotels and restaurants. Demand and supply will both soon settle, they say.

And all those wage rises we are seeing? They are probably a one-off as people are bribed to restart work and to shift from one sector to another. As furlough comes to an end and more people re-enter the labour market, it will all sort itself out.

Sure, the numbers are a little higher than expected, but – as I imagine the Bank of England’s Monetary Policy Committee will say when it meets next week – they are nowhere near high enough to stop the Bank “looking through” the current numbers to the settling down bit – and taking no action. Think of it the way Professor J Bradford DeLong of University of California at Berkeley does: burning rubber to rejoin the highway is not the same as actually running an overheated engine once you are on it.

...but you should probably be

I’m far from entirely convinced by this. There are hints in the wider measures of inflation that we should not dismiss last week’s numbers so easily. CPI is only just above target. But what about CPI at constant taxes, which excludes the impact of VAT cuts? That’s 3.8%, the highest level for 12 years.

And the retail price index (RPI), which until relatively recently was everyone’s go-to measure of inflation? That’s 3.3%. Then there is core inflation (which knocks out all the volatile stuff such as oil). That is up from 1.3% to 2%.

Then there are factory gate prices, now rising at a rate of 4.6%. Commodity prices have been rising fast and there is every chance they will keep doing so; apart from anything else governments are committed to chucking vast piles of money at the transition to renewable energy and this will continue to be a very commodity-greedy business.

Finally, wages. Inflation is caused by nothing more than the expectation of further inflation. If the price rises they feel around them make people expect more of the same, they will both ask for more money and spend the money they get faster, as they did in the 1970s when inflation went from 5% to double digits in the blink of an eye.

Add all this to the apparent imperative for all governments anywhere to spend to infinity on a variety of worthy sounding projects, regardless of the state of the post-pandemic public finances – see all statements from the G7 – and it is all worthy of rather a lot of worry.

What you can do about it

Your concern should probably not be rising interest rates on your existing debt (the Bank seems likely to spend rather too many years looking through inflation), although it is worth bearing in mind that if the rate on a repayment mortgage goes from 1% to 2% the monthly payments will go up by around 12%. Your concern should be your cash savings and the risks of rising inflation to stockmarkets.

For years now, asset markets have been all about working with falling inflation and interest rates with a vast side order of quantitative easing (QE). There is no bigger deal than that changing, as demonstrated by the scrutiny devoted to the US Federal Reserve’s revised (and accelerated) predictions on interest rate rises, delivered on Wednesday.

We should also look to the US for a hint of the misery ahead, say analysts at Gavekal. “For the last 130 years (the period for which we have data both for US prices and for the US stockmarket), all the excess return on US equities relative to cash have been realised during periods of decelerating inflation. The excess returns during periods of accelerating inflation have been a robust zero.

“Moreover, since 1945 every “ursus magnus” bear market (with a peak to trough decline of -50% or deeper) has occurred during a period of accelerating inflation”, they added.

Oh dear. So what do you do? Shift your cash to somewhere you can get 0.4% rather than 0.1%. Every little helps. Then shift your portfolio more towards companies that offer you cash now rather than promises of cash later (in an inflationary environment, now is better).

One place to get that is energy stocks. Everyone’s a bit down on Shell, for example, (and me, since I own it) but it is still paying you a yield of 3.4%. There’s a reason its share price is up 6% in the past week. I’m also tempted by the energy-heavy high dividend Russian stockmarket – but I will come back to that another week.

In the end, however, the best thing you can do to protect yourself from inflation is to attempt to make sure your income matches it. I’m pretty sure the Bank of England won’t approve of this suggestion, but here it is anyway: get ready to ask for a pay rise.

• This article was first published in the Financial Times

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