Why inflation matters
Inflation is the measure of how much the prices of goods and services have gone up over time. It reflects how quickly cash becomes less valuable. One of the basic aims of investing is to grow the value of your money against inflation which is often defined as a ‘real return’. For example, if inflation goes up 2% and your investment portfolio goes up by 5%, the real return would be 3%.
The Bank of England announced they expect the annual rate of inflation to stay around 5% each month until April 2022, when the next rise in the energy price cap could lead to another jump. The current annual rate of inflation is 5.1% in the UK and across the pond, the US have hit a 31-year high of 6.2%. This could have serious implications for the purchasing power of your money.
Chart showing the annual rate of inflation in the UK
Scroll across to see the full chart.
Source: Office for National Statistics, 15 December 2021.
Why the inflation spike?
Covid shocks and supply chain issues are the main drivers behind the inflation spike. We’ve also seen skyrocketing gas prices alongside the continual ramp up in demand for semiconductors and technology as people continue to work from home.
Governments and central banks have done a lot to support struggling economies and we’re now seeing the hangover effects. However, the end of the furlough scheme in the UK and hints that the Federal Reserve might end its pandemic-era stimulus sooner than expected shows the support is slowly being tapered out of the economy.
Transitory inflation or ‘here to stay’ inflation?
The word ‘transitory’ has risen in popularity across the news with Google searches for the word doubling in the last year.
Chart showing Google searches for the word transitory
Scroll across to see the full chart.
Source: Google Trends.
Transitory inflation is the view that a period of high inflation will be short, but not sweet. Some think the current spikes are temporary in nature, and they’ll return back to the target rate of 2% in the UK. In the US, however, the target is slightly different. The Federal Reserve targets an average inflation rate of 2% over time, giving it more flexibility in achieving its aim.
It’s important for investors to keep an eye on inflation rates both here in the UK and overseas, as rising prices can add uncertainty about the outlook for the economy and the companies you invest in.
Investing to combat inflation
One option to tackle inflation is to track a benchmark of inflation-linked bonds. Inflation-linked bonds are tied to the costs of consumer goods as measured by an inflation index like the consumer price index (CPI) or retail price index (RPI).
Passive, or tracker funds are convenient, low cost and simple to understand, generally investing in all the same holdings as a benchmark. It will aim to track its benchmark closely to deliver a similar return. Of course, this can work for and against you depending on the direction of the benchmark.
Inflation and interest rates are closely linked. As inflation rises, central banks often raise interest rates as a tool to dampen rising costs and cool the economy. This poses a risk to the price of inflation-linked investments if interest rates rise in the future.
Alternatively, investors could consider an active approach. Read our latest article on the topic.
If opting for a passive approach, one way investors can try to track inflation is by using funds. We’ve included two ideas that investors could use for exposure to an inflation-linked benchmark, but they’re not a personal recommendation to buy.
Investing in funds isn’t right for everyone. You’ll need to consider your own goals, attitude to risk and wider portfolio before making any investment decisions. Funds can fall as well as rise in value and you could get back less than you invest.
As always, we think a well-diversified portfolio – including a mix of investments types like shares and bonds across a range of geographies and investment styles – is a sensible long-term strategy for lots of investors.
This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. All investments and any income from them can fall as well as rise in value, so you could get back less than you invest.
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