Welcome to some more Friday financial musings. I hope this finds you well and looking forward to the weekend.
I apologise in advance if this piece threatens to derail your diet plans, but today we are talking about inflation and chocolate. And I don’t mean the inflation of waistlines as a result of eating too much of it, but rather the kind of inflation that makes your chocolate (and pretty much everything else) more expensive.
As many countries across the globe continue to wind down their lockdown measures and begin to function more normally again, the main talking point in economics seems to be shifting from elation at the pace of the economic recovery, to concern over the potential for sharp increases in inflation.
As I began to write this I realised it still sounded rather dull, so thought I would tell part of the story via the medium of chocolate. After all, the age old metric of the cost of a pint of beer seems less relevant at the moment, given that none of us have set foot in a pub for a good 12 months.
So, to begin, just what is meant by inflation in economics?
Well, to quote former baseball player Sam Ewing: ‘Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair…’
Inflation is the ongoing increase in the cost of goods and services. It’s an important economic indicator as it influences how much spending power consumers have. In an environment of rising prices, your money doesn’t stretch as far. Or as our US cousins might say, you get ‘less bang for your buck’. Inflation can be used to chart a general increase in prices across the economy, or sometimes a specific product or service. There are a number of different kinds of inflation and I’ve summarised the key ones below, using chocolate as an example.
Different Types of Inflation
Picture the scene; you’re at the petrol station. You fill your car up with fuel and go to pay (electric car owners - play along please). As you’re stood in the queue, the confectionary display begins calling to you. Your willpower crumbles, you reach for your favourite chocolate bar and pop it on the desk for the cashier to scan.
1) Inflation – a measure of the increase in the cost of goods and services.
Your chocolate bar is noticeably more expensive than last time you bought one. You are somewhat disgruntled, but buy it anyway.
2) Disinflation – a decrease in the rate of inflation.
Your chocolate bar is marginally more expensive than last time, so you probably don’t notice.
3) Deflation – a reduction in the cost of goods and services (rare, sadly).
Your chocolate bar is cheaper than last time you filled up. You rejoice, buy two, but throw the empty wrappers in the bin, so your other half doesn’t find them.
4) Stagflation - a rapid increase in the cost of goods and services, but when economic growth is low, and unemployment is high. (very rare, thankfully)
Your chocolate bar is not only more expensive, but it’s significantly smaller too (Toblerone, I’m looking at you). You put it back in disgust. The chocolate producer makes someone redundant due to falling demand for their product.
5) Hyperinflation – a rapid, excessive, out-of-control increase in the cost of goods and services, measuring more than 50% per month. (extremely rare, unless you live in Zimbabwe)
Your chocolate bar now costs more than your tank of fuel. You flee to your car in shock and see if there are any old sweets left in the glovebox instead.
When inflation is high, many consumers cannot afford to buy all of the things they need and want, which leads to a fall in the standard of living. Whilst obviously not good for the individual, it can also be bad news for the economy as a whole. If wages growth doesn’t keep up with inflation and consumers have less buying power, this can dampen economic growth.
A little inflation can however be good for the economy, as it can create spending momentum, encouraging people to buy things today rather than wait until tomorrow. This can then enable companies to increase wages, putting more money in people’s pockets to spend. A lovely virtuous capitalist circle that isn’t so bad for most working people then. But what if you’re retired? More on that in a moment...
The official measure of inflation in the UK is the Consumer Price Index, a.k.a ‘CPI’. It is a weighted index that measures the rising cost of a wide range of products and services, frequently purchased by your average Brit. The government’s long term target for inflation is 2% per annum.
How does inflation affect me and what should I do?
Well, if you’re still working, you probably shouldn’t worry too much. Earnings growth in the UK in the recent past has been in excess of inflation, meaning that if anything, the average working Brit has seen their spending power improve. For you to really feel it in your pocket, inflation would need to spike then stay higher than earnings growth for a protracted period of time.
If you are working, whilst it’s important to hold an emergency fund for rainy days, you still shouldn’t hold too much cash on deposit for a long period of time. With interest rates having been on the floor for the last decade, after taking inflation into account, your savings are losing value in real terms. Usually it is best to invest surplus income and capital, targeting a real return over and above inflation. ISAs and pensions are a great place to start due to their tax advantages, but there are plenty of other options too. Long term investments with stock market exposure remain one of the best ways of protecting your capital from inflation.
Inflation can be a much greater threat to those who have retired however. State pensions are index-linked, meaning they keep their spending power over time. So too are final salary pensions, which is why if you are lucky enough to have one, it’s almost always worth hanging onto it. So those with full state pensions and strong final salary pensions remain well protected against inflation, however, active final salary pensions now only exist in the public sector.
For business owners and private sector workers heavily dependent on savings, investments and private pensions, to provide for their spending needs in retirement, inflation is a very real and present danger. The thief in the night plundering your retirement savings and eroding your spending power, often without you even noticing. For those in this situation, it is especially important not to hoard too much cash. Having the right retirement income and investment strategy is vital. You need to ensure your capital is working for you and at least keeping pace with inflation, to help ensure your standard of living can be maintained throughout retirement.
This is one of the key reasons we build cashflow plans for our clients and what makes them especially useful for retirement planning. They help us understand your future spending needs and establish the right investment strategy, taking key factors like inflation into account. In this way we’re always keeping an eye on the future and can adapt your financial plan if economic conditions – such as inflation - do begin to move outside of our expectations.
The current debate around inflation is a lively one and no-one can predict exactly what will happen. However, our own view is that higher inflation is likely to be a short term phenomenon here in the UK. The pent-up savings accrued during lockdown are now finally being released into the economy. Demand for goods and services, especially those provided by the hospitality and travel sectors, is understandably high and likely to be so for some time. This will inevitably put upwards pressure on prices for a time. However, once people have sated their desire for spending, eaten their fill and burnt themselves to a crisp on those long-awaited summer holidays, a return to more spending patterns seems likely.
Even if inflation does spike, once supply and demand rebalance, hopefully it will fall back to more normal levels. So next time you buy that chocolate bar, hopefully it will be only marginally more expensive than before. If you nodded sagely and murmured ‘deflation’, then I know you’ve been paying attention...
With that I’ll close for the weekend. If you have any burning questions about inflation, or anything else financial, please feel free to get in touch.
