Inflation and Investments

January 30, 2020
Taryn Lee-Johnston

Inflation is basically another word for price increases.  Its opposite is deflation.  Inflation matters because it influences the cost of goods and services and hence how much income we need to support our lifestyle.

Measuring inflation

In principle, you can measure inflation (or deflation) by tracking the price of an item over time.  In practice, the price of a single item is unlikely to be all that relevant in the general scheme of life (with the possible exception of housing), so official measures of inflation tend to track groups of goods.  For example the Consumer Price Index (CPI) tracks price changes across a wide range of household goods and services including food, clothing and recreation.

Factors which influence inflation

Inflation can be influenced by many factors but most of them revolve around the twin concepts of supply and demand and affordability.  For example, if an item is in low supply but demand for it remains high, then its price will go up.  This can be seen both directly and indirectly.

A direct example would be farmers losing crops to a bad harvest, people still need to eat, so food prices would be expected to go up.  An indirect example would be a shortage of the raw materials needed to make manufactured goods.  If there was still demand for the goods, manufacturers could, in principle, still make them, but they might need to pass on the additional costs to consumers.

The issue of affordability can also be influenced by various factors but three of the most obvious are taxes, currency rates and interest rates.  If governments increase taxes on an item (for example on unhealthy products such as tobacco), then either the manufacturers will have to absorb these (reducing their own profits) or they will have to pass them on to customers.

Currency rates can influence the price of goods and services which require materials and/or labour to be bought from another country using another currency.  Basically if the Pound weakens against the other currency, the effective price of the goods or services will increase (creating inflation) and vice versa.  A strong Pound is not good news for everyone since it makes goods and services produced in the UK more expensive to international buyers and hence has the potential to reduce exports.

In the UK, interest rates are set by the Monetary Policy Committee at the Bank of England, which is tasked with keeping inflation at exactly 2% although they have a 1% margin of error, either way.  When inflation increases, the MPC can raise interest rates to increase the returns on cash deposits and to make borrowing more expensive.  When it decreases, the MPC can lower interest rates to reduce the returns on cash deposits and make borrowing more affordable.  They can also use quantitative easing.

What inflation means for investors

There are two reasons why inflation matters to investors.  The first goes back to the opening point regarding the fact that inflation influences the amount of money we need to earn to be able to live our lives.  If you’re reliant on investment income, then you need to ensure that you factor inflation into your calculation of you much yield you need to generate for your living expenses.

The second is that inflation, and perceptions about its future direction, can influence the performance of different asset classes.  For example, if there is a perception that interest rates will go up, then people might hold off buying bonds because they expect to get better value for them in the near future, whereas if there is a perception that inflation might go up, people might be more interested in shares as they can offer higher returns which improves the chances that they will at least keep pace with inflation if not outpace it.