With the reductions to the headline rate of inflation in recent months, you might start to feel like things are starting to come under control. Here we take a look at some of the main factors which have driven the recent falls and look further as to what this could mean for both savers and investors in the medium to longer term.
Moving in the right direction
Last week the Office for National Statistics revealed that the annual headline inflation rate decreased in May as the Consumer Price Index (CPI) fell to 2.8% from 3%. The Retail Price Index (RPI) also fell from 3.5% to 3.1%. The biggest downward pressure for these latest figures was fuelled by a drop in petrol prices as well as in the food and non-alcoholic beverages sector.
The latest results mark a second consecutive fall in inflation with CPI at its lowest level since November 2009. At face value this is good news and certainly gives a feeling of things moving in the right direction.
Further quantitative easing likely
However, the news is not all good. Since this rate is getting closer to the Bank of England’s target rate of inflation, the potential for further quantitative easing (QE) may be on the horizon, with economists stating this gives the Bank of England room to restart QE as early as next month.
Investec UK economist Philip Shaw told the Telegraph*: "With inflation coming down sharply over the past couple of months, the economic data disappointing and global uncertainties rising, there doesn't appear to be much cause to hold back."
Impact on savers?
Combined with the previous week’s announcement of £140 billion of cut-price loans from the government, this is potentially a double blow for savers since banks may have less pressure to entice savers with higher rates. Savings rates are already at extremely low levels relative to previous years, particularly fixed rates which have noticeably tumbled in recent years.
With there being a very real possibility that the base rate could be cut further to 0.25% by the end of the year, the situation is perhaps not as simple as inflation finally coming under control. The ultra-low interest rates and money printing in the form of QE have not produced the growth envisaged, but rather three years of continued alterations to future growth forecasts, normally downward.
The golden days of high interest rates is not only well and truly behind us, but is nowhere near looking like returning in the coming years and it seems the only ones to benefit from the government’s ongoing fiscal policy are the banks themselves.
Bank ratings lowered
And yet despite this, on Friday last week Moody’s, one of the three largest credit ratings agencies, downgraded 15 global banks and financial institutions, including RBS, Barclays, HSBC and Lloyds in the UK. This is as a direct result of the eurozone crisis and fears that this will prompt another credit crunch by making banks afraid of lending to each other, let alone to anyone else.
This followed a cut to Santander UK’s rating last month and although these downgrades were expected and should create little in terms of too much immediate concern from savers, it does all add to the overall negative feel of the future economic outlook and the uncertainty around inflation.
So what will happen to inflation?
What is evident from the above is that to focus in isolation on the recent falls in the headline rate of inflation, from its peak of 5.2% in September 2011 to its latest level of ‘just’ 2.8%, is far too simplistic and could lead us into a false sense of reassurance.
Remember that this is only the current rate of inflation and that the factors which contribute to the headline rate going forward are complex and varied. This means that what might happen in the future is nowhere near settled or guaranteed and so the only way to plan for the future is to look in more detail at the main factors that create inflationary pressures.
One of the catalysts for the recent reduction is that the sharp increase in commodity prices seen at the end of 2010 and during 2011 has since reversed and the latest decrease reflects this, with a main contributing factor being the reduction in the price of motor fuel.
However, although the current economic environment is not supportive of commodity prices in the short term, the political will to foster a return to economic growth will create upwards pressure on commodity prices, which is likely to feed through to higher inflation. Not only is this highly likely to occur, but this could also happen very quickly and without much notice.
Money flow and reaching the broader economy
Another critical factor is that although the UK government, via the Bank of England, has flooded the financial system with easy money via QE unfortunately little of this has reached the broader economy and so again, the only ones to seemingly benefit thus far have been the banks. What is clear is that for a long lasting return to solid economic growth this liquidity needs to find its way into the hands of the consumer and businesses.
This was in no small part the reason for the announcement from the government last week to implement the £100 billion ‘Funding for Lending’ scheme. These loans are being made available on the condition that banks increase their lending to businesses and households, something which the government had hoped would have happened already. What has not been commented on is that once these measures gain traction and money does eventually feed through more quickly to the wider economy this is also likely to force inflation to rise.
Reduction of government debt
One final aspect of the current crisis that also points to an increase in inflation is the need to consider the sheer volume of debt which is owed by the UK government and the budget deficit this creates which still equates to around 8% of GDP.
The future value of outstanding debt is directly affected by both time and, critically, inflation. As an example, after 10 years of inflation at a rate of 3%, the future value of debt would stand at 75% of its current value. It is therefore an easy method for the UK government to reduce their debt burden by allowing inflation to increase.
The combination of these factors suggests the potential for inflation to increase significantly over current forecast levels in the medium term. In recent years, Bank of England inflation forecasts have been worryingly loose and inaccurate and perhaps now we can start to understand why.
As savers and investors, the recent falls and current headline rate of inflation must not be taken at face value when making decisions that tie up your money for any period of time. The return of the UK to solid growth is not a simple one and inflation is inextricably linked to the way forward.
Exactly what shape this will take is unclear but with so many indicators pointing to an increase, potentially by some margin, we must understand what this could mean for our savings and investments. Having an eye on what could happen before acting could be a wise move and the impact of ignoring this could be very costly indeed.
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* source: Telegraph online, 20/06/2012
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