Inflation or deflation? That is the question...
...Which is more beneficial to savers?
Since 2008, investors have been questioning whether it is inflation or deflation that haunts them. One might imagine that by now we would be closer to knowing the truth but, in our experience, the answer to these ‘either/or’ questions is almost always ‘neither’. When the two options are polar opposites, some combination inevitably turns out to be the true path.
When approaching the question from a scientific perspective, the answer is easy. There has historically been inflation and too much of it. In March 2004, the Chancellor gave the serving Governor of the Bank of England a mandate to target growth in the Consumer Price Index of two per cent per annum. Initially the Bank achieved this, but recently that target has been missed more often than it has been hit.
Cumulatively, prices are now seven per cent higher than the Chancellor had intended when the inflation target was set. And that overshoot has all accrued in the years since 2008.
So inflation then is the clear winner of the inflation/deflation debate of the last few years. Or is it? When we talk about inflation we are normally talking about consumer or retail prices, but other things inflate too: wages and salaries, for example. In fact, the UK has seen incomes rise faster than prices for decades (back to the 1960s at least). But that stopped in April 2009. Since then earnings have fallen in real terms by some nine per cent – leaving them 11 per cent behind the trend rate of real earnings growth. Therein lurks the deflation.
This creates a real dilemma for the Bank of England because, on the one hand the inflation they are supposed to be targeting is high, but because wages are lagging behind prices, this actually restricts disposable incomes.
The explanation for what we reluctantly describe as ‘deflationary inflation’ is that much of it arises from higher taxes such as VAT or payment of tuition fees. . The other source of inflation has been the weakness of the pound. When the pound falls, as it did sharply at the end of 2008 and again earlier this year; the prices of imported goods rise.
The typical way to fight inflation is to raise interest rates, but this would simply compound the squeeze on households’ expenses by adding higher mortgage payments to their woes. The monetary policy committee argues that tax increases and sterling devaluations are one-off increases in prices, rather than an on-going trend. . Therefore, their best course of action is to cut rates, take the pressure off household finances, and thereby head off the risk of serious deflation further down the road. The problem is these one-off events have been happening all too frequently.
It is against this background that the reins of the Bank of England are being handed over to a central banking celebrity, Mark Carney.
Speculation is rife about whether the new Governor, Mr Carney will find new ways of being easy on us. Will he target growth instead of inflation? Most would conclude the bank has being doing that for the last four years. Will he commit to even lower interest rates? This policy could tie his hands if the inflationary picture evolves in unexpected ways. Will he prime the presses for another round of QE? Beyond the weaker pound it is yet unclear what the benefits of QE have been, other than the threat of inflation down the road.
The real result of all these easing policies is that they affect a transfer of wealth from the UK’s savings to the Exchequer, which pays less interest on its future borrowing as a result while the burden is felt by the decline in the after-tax value of savings, held in banks or invested in government bonds.
This leaves savers as ever with a difficult choice, when we are experiencing the dual demons of inflation and deflation. Do you invest in equities for a chance of maintaining or growing real wealth? Or do you hold cash or low risk bonds, which are unfortunately very likely to lose money after tax and inflation? We continue to believe the former to be the right course, with a fair sprinkling of the latter.
Brian James - Head of Office: Brewin Dolphin Plymouth
