Should we be worried about inflation?

Inflation rose to 2.1 per cent in May 2021, breaching the Bank of England’s target of 2 per cent for the first time since July 2019. After so long living in low central bank interest rate conditions, it might be an indicator of a change in the relationship between our disposable income and the things we buy, while its effect is far-reaching, from everyday spending to retirement strategies.

Inflation is a result of rising prices and this is measured by the Consumer Prices Index (CPI). The CPI is a combined series of the changes in cost of a number of sectors in our economy, reflecting whether they have become more or less expensive over the last twelve months.

In the most recent measure of May 2021 (released 16th June 2021), transport increased by 0.72 per cent, reflecting the rising cost of fuel in that time and other significant increasing factors included clothing, recreational goods (particularly games and recording media), and meals and drinks consumed out.

Clothes prices rose by 3 per cent compared with last year, the price of a haircut by 7.9 per cent and restaurant prices by 1.7 per cent.

The biggest increase was in transport, where there was a 17.9 per cent increase in motor fuels. Average petrol prices were 127.2p a litre in May, compared with 106.2p per litre a year earlier, when lockdown was in full effect and few cars were on the road.

There was a 2.7 per cent increase in the prices of toys and games, a 5.8 per cent rise in sports and outdoor goods, and a 3.4 per cent rise in recording media, “principally music downloads”, the ONS said.

Philip Aldrich, writing in The Times, summarised why the cost of goods has increased.

“Output producer prices, also known as factory gate prices, rose to 4.6 per cent, the highest level since January 2012. Input producer prices, the cost of materials, jumped by 10.7 per cent, the highest rate since September 2011. Inflation is on the march globally, rising by 5 per cent in the United States in May — a 13 year high.”

How did it happen?

Since Covid hit in the early part of 2020, central governments have responded by stimulating the economy. This included measures such as the stamp duty holiday, to encourage consumers to keep spending when their instincts were probably to preserve cash, given the uncertainty of the situation.

The Furlough scheme is another factor here. It pumped a lot of money into the economy by subsidising wages, while the Bank of England launched an £895bn quantitative easing programme to ensure the economy kept running at ‘normal’ levels and didn’t grind to a halt.

However, the situation now is that much of that money remains in circulation and consumers have saved a lot of money (the UK’s average household savings ratio exceeded 25 per cent in 2020 from a typical rate of 5-10 per cent in the preceding five years).

The unlocking of the economy and loosening of Covid restrictions, combined with rising prices from manufacturers and the sheer amount of cash available to spend has pumped prices up. We’re also seeing low levels of unemployment, which typically means that wages will rise as fewer workers chase each vacancy.

At a macro level, immigration for work is on hold at the moment because of countries closing their borders, while the UK has still to coherently set its stall out for how it will allow immigration post-pandemic in light of Brexit, which is causing a shortage in certain industries.

However, inflation also has to be seen in the context of the last few years as a whole. Inflation was negative or very low for most of 2020 and the start of 2021, so the rise now appears to be starker.

What’s going to happen next?

Policy makers, including the Bank of England, try to control inflation so that it doesn’t continue unchecked and we spiral into an ever-increasing state of rising prices and rising wages, or hyperinflation.

One option is to increase the cost of borrowing so that people are discouraged to spend and encouraged to save. Since the credit crunch of 2008/9, policy has been to discourage savers as the Bank of England fought against sluggish growth, meaning that the Bank of England base rate has remained at historic lows. In that time, homeowners have benefited from low mortgage rates as the cost for their bank to finance mortgages has been low. We might see the base rate voted upwards by the Bank of England’s Policy Committee if inflation continues to rise.

There is a level of inflation that the Bank of England is happy to live with though, particularly as the government will probably chase economic growth in the aftermath of the pandemic. Therefore, there might not be any immediate change and if prices settle across the globe and the impact of post-Furlough does come through negatively by increasing unemployment and reducing household expenditure, as has been anticipated, things might correct themselves.

Why it matters

In order to maintain purchase power – i.e. money allowing us to buy what we need without it costing us more, then we need money to be appreciating by at least the same as the rate of inflation. For example, if the cost of a loaf of bread rises from £1 by two per cent and your wages have remained static, or your savings are in an account paying you 0.1 per cent, it will cost you £1.02 and you need to find that 2p from your wages or your savings. This is a small value, but replicate that across your utility bills, travel, weekly shop and other household expenses over the course of a year, and it becomes a bigger problem.

It’s sensible to keep some cash for emergencies, for purchases and an unexpected fall in income, but it’s important to make sure you’re not holding too much in cash, as it will lose value over time due to inflation. And the UK has a lot of cash saved after the pandemic.

What can we do about inflation?

When it’s actually happening, not a lot, unfortunately. If you’re employed, you could push for an annual wage increase in line with inflation or get another job. Also, as the CPI is an amalgamation of prices of multiple goods, you could avoid those with the highest price increases – although that would be impractical for fuel if you need to drive a car or simply a lot of hassle for basic household goods.

The best course of action is for your financial adviser to construct your finances so that inflation is accounted for. Your adviser will make sure you’re:

• Using your personal allowances to save as much tax as possible. Paying tax will almost always cost you more than the effects of inflation
• Minimising the amount you need to hold in cash so your overall estate is not at risk of losing value over time
• Investing in strategies designed to deliver investment returns that outstrip inflation (in line with your attitude to risk and capacity for loss, of course)
• Withdrawing from your pension flexibly (if you’re in flexi-access drawdown), to account for inflation and investment performance simultaneously, so it doesn’t affect your overall financial planning objectives

What about retirement products?

Those with an annuity are most at risk from inflation. The annual amount that a retiring person’s pension pot is traded for does not always adjust for inflation (sometimes it has to be added on as a feature), so there’s a risk of purchase power depreciation over time.

Pensioners with flexible access to their pension pots could also be affected by inflation. However, they have the option to draw down more to cover inflation. With the bulk of their pension still invested, strong investment performance could create additional funds to withdraw, without it affecting the long-term withdrawal strategy.

A £4.7bn elephant

The elephant in the room is the state pension, which is a key component to many retirement strategies and is guaranteed to beat inflation. The Triple Lock law means the basic state pension and the new state pension are increased by the highest of three elements on an annual basis.

These are the growth in average earnings; the growth in prices as measured by the Consumer Price Index; or a floor of 2.5%.

It is also a legal requirement that the increase be at least in line with average earnings.

As it stands, earnings growth looks to be the element rising fastest, at 5.6 per cent in April. The context here is that the UK spends £85bn on its pensioners annually, so a 5.6 per cent growth would add £4.7bn to the bill, at a time when the UK is trying to recover from the highest level of state spending since the Second World War.

Politically, this feels like a very thin piece of ice for the Chancellor to skate on. He has options, such as linking to underlying earnings growth, which discounts the impact of wage reductions in the economy through the Furlough scheme and the removal of lower paid jobs in the economy due to closures of hospitality, which has increased the ‘average’ wage. This figure would be about three per cent.

However, the government could expect strong resistance to any significant increase in the state pensions from a younger population who already feel that they’re going to be stuck with the burden of repaying eye-watering levels of state borrowing.

Now might be an opportune moment for the Government to re-evaluate the Triple Lock as a policy, especially given its stated desire to level up the economy and to manage its debts. Furthermore, given that the social care crisis has yet to be resolved, it could be a more prudent use of resources to divert them to that sector and tackle it instead.

As for inflation, given the extraordinary conditions of the last twelve to eighteen months (remember Brexit happened) and the great unknowns of the future, such as the vaccine, whether state aid will continue in the event of another variant outbreak, or frankly, anything that hasn’t been foreseen just yet, we may expect inflation to rise and fall fairly dramatically, as policy makers struggle to work out which way it will go.

For the past 26 Bank of England Monetary Policy Committee meetings, members have only voted differently to each other on four occasions. All things point towards much more variety in the minutes going forward.Your home may be repossessed if you do not keep up repayments on your mortgage.
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A pension is a long term investment. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Pension income could also be affected by interest rates at the time benefits are taken. Accessing pension benefits early may impact on levels of retirement income and your entitlement to certain means tested benefits.  Accessing pension benefits is not suitable for everyone.
You should seek advice to understand your options at retirement. The Financial Conduct Authority does not regulate taxation advice.