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The Impact of Inflation

21 Oct 2016

Ben Kumar, Investment Manager

Inflation is on the rise. The latest numbers state prices increased to 1% in September, up from 0.6% in August, according to the office for National Statistics. But what does that mean?

Inflation is on the rise. The latest numbers state prices increased to 1% in September, up from 0.6% in August, according to the office for National Statistics. But what does that mean?

Inflation is a bit of a strange concept. In many ways, it’s viewed by economists in the same way that Goldilocks considered porridge – there is a level that is just right, but extremes are bad.

Most people think about inflation less often than economists or central bankers, but it is arguably more important to our lives than it is to economic models.

Inflation is all about how much it costs us to live the same lifestyle. If we were to change nothing about the way we live, would it get more or less expensive every year?

If the cost of living falls, that’s deflation. If it rises, that’s inflation.

One of the reasons for saving is that you have more money for your retirement. And you will want to see your pot of money increase at least in line with inflation. That ensures that the mere passing of time does not make you poorer.

Making that return on your cash has become harder over the past few years, with interest rates basically around zero. Bank accounts and cash ISAs provide negligible returns. For example, if you have £25,000 in a high street bank ISA and its interest rate remains at 0.01%, even if the investment is over 20 years, it will only grow by £50.05. Meanwhile, the effect of 1% inflation on that £25,000 (including that return) would mean you’re left with spending power of just £20,497.72.

However in recent times, while cash has provided miserable returns, inflation has also been around zero. In that world, spending power is preserved.Investors risk being left behind if they stay in cash as their spending power is eaten away year by year.

The recent increase is apparently only the beginning of an upward trend. By the middle of next year, the Bank of England’s target is 2%. Some are putting the level at 3%. Yet interest rates are still at record lows, and the only change over the same period could be that they may go lower. Investors risk being left behind if they stay in cash as their spending power is eaten away year by year. In this case, investments are worth considering.

Investing in equities or bonds is often (correctly) described as risky – meaning that returns are not guaranteed. The value of your investment can go down as well as up over time, and you can lose more than you originally invested. In an inflationary environment, investments in cash won’t fluctuate. They will just steadily lose money for you every year. That may not be the kind of ‘stable’ return investors are looking for.

7IM aims to manage money to expected returns. Our lower cost balanced strategies, as an example, looks to yield around 6.2% per annum over the medium to long term. With a 2% inflation rate that still means your money is potentially up in real terms by 4.2%. Suddenly that may be more than common sense.

Ben Kumar
Investment Manager

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The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.

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