Staying ahead of inflation when it returns

THE Consumer Prices Index (CPI), the measure of inflation used by the government as its official measure, has hovered around zero throughout 2015.

It is important to understand exactly why inflation is so low. The CPI rate is a simple comparison between prices now and where they were a year ago.

The price of oil 12 months ago was approximately double its price today which has obviously had a significant effect on prices and this, alongside an increasingly intense price war between supermarkets, is a major factor in the lack of inflation.

Both the Chancellor and the Governor of the Bank of England expect inflation to return to more ‘normal’ levels when the effect of the fall in oil prices drops out of the CPI calculation but there appear to be few upward pressures that will affect UK inflation in 2015 and even 2016.

The lifting of sanctions against Iran and problems in China will mean that oil prices are unlikely to increase. Indeed, recent comments from the Centre for Economics and Business Research indicated that inflation could remain below the Bank of England’s two per cent inflation target until 2017.

The Bank of England is concerned that while the majority of deflationary pressures in the UK are driven by non-UK factors, domestic inflationary pressures such a household demand and earnings rises are causing tensions in the economy.

It is difficult to predict when the Bank of England will finally increase interest rates from their record low but there are clear signals that this will be well in advance of inflation hitting the Bank’s two per cent target.

Those with even moderately long memories will remember many years of significantly higher levels of inflation but it is easy to forget the damaging effect on the value of savings and investments that inflation causes, especially when it exceeds returns. If inflation is just 1 per cent, it takes over 72 years to halve the value of an asset, a timescale that becomes almost irrelevant to the majority of people.

If inflation reaches three per cent, the value of an asset is halved in only 24 years, a period that becomes much more meaningful when making long term financial plans.

The State Pension, with its ‘triple lock guarantee’ increases by at least 2.5 per cent each year meaning that virtually all pensioners are seeing a real rise in their income and those fortunate enough to have retirement income provided by a defined benefit pension scheme will normally enjoy index-linked income.

Savers, even with interest rates at historically low levels, can find a real rate of return at the moment without too much effort and investors are often reaping significant real returns.

Those who are, to a greater or lesser degree, dependent on a return on their capital, either through savings or pension funds, should not be complacent.

This period of low inflation is an opportunity to get ahead of the long-term game.

Well managed investment in assets such as equities has consistently provided returns ahead of inflation and the risk and volatility associated with equity investments is acceptable to the majority who are investing on these longer time scales.

Inflation, when it returns, will once again become a major threat to the long term security of investors so it is important to act now to build an asset structure that will match or, hopefully, exceed inflation over the years. Trevor Law is a director with

Merito Financial Services, chartered financial planners,

based in Solihull. E-mail: tilaw@meritofs.com