Inflation is good...the alternatives are not!

The UK has seen inflation rates gradually falling in recent times, with recent falls appearing to accelerate. There is no guarantee that this trend will continue, but with current inflation rates standing at 2.3% RPI (Retail Prices Index) and 1.2% CPI (Consumer Prices Index) in the year to September 2014 (source: Office for National Statistics), the possibility of stagflation, and even deflation, and their consequences, need to be revisited. 

As you will see, inflation, believe it or not, can have its benefits.

Stagflation

The term 'stagflation' refers to a combination of ‘stagnation’ and ‘inflation’. Stagflation is an economic phenomenon characterised by slow economic growth and rising prices. The term was first coined in the 1960s in the UK to describe the combination of a stagnant economy, increasing unemployment and rapidly rising inflation owing to dramatic upward movements in world oil prices. Stagflation hit the UK hard in the 1970s, as rising inflation and lack of employment opportunities stifled economic growth. 

There are a range of theories about why stagflation occurs. Keynesian economists cite supply shocks as the cause, for example rapidly rising oil or food costs. Others blame excessive growth in the supply of money – as Milton Friedman described, “too much money chasing too few goods”. It has also been argued that stagflation is just a natural part of the modern economic cycle or that political and social structures are responsible for the phenomenon.

Whatever the cause, stagflation raises serious dilemmas for economic policy because actions designed to reduce unemployment may exacerbate inflation, and vice versa.

Deflation

Deflation is the opposite of inflation - a general decline in the price of goods and services. It occurs when the inflation rate becomes negative, i.e. when the inflation rate falls below 0%. Deflation is often caused by a reduction in the money or credit supply, although it can also be caused by a decrease in spending by the state, the consumer or the financial community. Deflation increases the real value of money over time. This is because consumers will hold back on purchases of goods and services with the expectation that the price of these will fall over time. This fall in demand, combined with an increase in the real value of debt, leads to increased unemployment, which in turn can lead to economic depression, as seen in the US between 1930 and 1933 when the rate of deflation was rapid, banks failed and unemployment peaked at 25% of the population. 

Japan: 20 years of deflation

Japan has experienced deflation and its effects since the mid-1990s. The initial shock came in the early 1990s with the bursting of the economic ‘bubble’ of super-inflated property and stock market prices. The subsequent collapse lasted for more than a decade, as the slump in demand caused by the bursting of the asset bubble resulted in Japanese firms being unable to raise sales prices and cutting wages and employment as a consequence. From the late 1990s onwards, wages began to fall faster than prices and deflation became entrenched. With no incentive for firms to invest, the economy became trapped in deflation, with falling prices, falling wages and falling investment combining to maintain the downward pressure.

Is there a lesson here for Europe and the UK?

Firms in the Eurozone are responding to the lack of demand and their inability to impose price rises with a conviction that cutting labour costs is the route back to competitiveness. This is worryingly reminiscent of the vicious circle in which Japan became trapped in the 1990s and the threat of deflation is therefore of real concern to Eurozone leaders.

Summary

It will be interesting to see how the next few months pan out for the UK economy and the way that the Bank of England uses its financial tools to control, where possible, the outcomes. Inflation, against its alternatives noted above, can have its ‘benefits’. With many now suggesting that Bank Base Rates (currently 0.5% pa) will stay at this level until summer 2015, the effect of inflation or stagflation….or worse, could have a real effect on the value of the money we have to spend over time.

No individual pension/ financial advice is provided during the course of this blog.

If you would like guidance and advice on your income planning for the future then please contact the team at Chapters Financial at either our Guildford (01483 578800) or Woking (01483 330800) offices.

Keith Churchouse BA Hons FPFS
Director, Chapters Financial Limited
Chartered Financial Planner
Certified Financial Planner
ISO22222 Personal Financial Planner

Chapters Financial Limited is authorised and regulated by the Financial Conduct Authority, number 402899.

The continuing conundrum for savers / 'Forward Guidance'

The new economic tool deployed by the new Governor of the Bank of England, Mr Mark Carney, in August 2013 was heralded as the opportunity to manage economic, and to some extent financial, expectations into the future. 'Forward Guidance' as it is known, provides all those affected by the economy with the opportunity to know how the Bank of England predicts the future, and more importantly, what they plan to do if these expectations are met.

As we have seen, Forward Guidance has linked the Bank Base Rate (currently 0.5%) to UK unemployment levels (currently 7.8%) with the plan that Base Rates will remain at their current level until the unemployment level falls below 7.0% (Subject to anything unexpected happening, which it can). With this plan in mind, the Governor does not expect the target of 7.00% being reached for around 3 years, and therefore does not expect Bank Base Rates to move either in this time.

This new direction provides the benefit of certainty for some (such as businesses and mortgage borrowers as examples), but also provides the negative certainty of continuing low returns for savers.

Many savers have seen returns falling in recent times, with Premium Bond returns also falling from August 2013 onwards. Many are resigned to this situation, sensibly using their tax efficient ISA allowances where possible to reduce the tax take on any gross savings earned.

Against this backdrop, some clients and enquirers are reviewing their attitude to investment risk, where appropriate, and applying this review to their future investment decisions. As an example, UK Dividend returns have remained relatively firm over the last year and these have typically been between 3.00-4.00% gross pa (Not guaranteed, past performance is not a guarantee of future performance). Obviously, by moving into this investment area, the risk to the capital invested increases significantly, with the value of funds varying daily. This volatility (and overall investment risk) is detailed on our Investment Risk Scale further here (Link). However, if an investor is prepared and able to accept this level of investment risk, this investment alternative may be suitable in some investment cases. It should be noted that diversifying any investment is usually worthwhile and we have noted that committing smaller sums initially may be worthwhile to get used to the chosen investment medium before committing larger sums.

Each investment plan and recommendation is different and individual to the Client. To consider your circumstances with regard to savings and investments, you should take individual financial advice. No individual advice is provided in the content of this Blog. The team at Chapters Financial can help you with your planning and look forward to working with you.

Keith Churchouse FPFS
Director
ISO22222 Certified Financial Planner
Chartered Financial Planner
Chapters Financial Limited

Chapters Financial Limited is authorised and regulated by the Financial Conduct Authority, number 402899.