When you hear the word “inflation”, you should mentally boo and hiss as if it’s a pantomime villain.
Actually, no: there’s nothing pretend or exaggerated about inflation, so that’s the wrong response. You should get angry when you think about inflation.
If your reaction at the moment is indifference or bemusement rather than anger…stay put. I’ll aim to change that by the end of this article.
Why is inflation so dastardly?
Normally, you can see bad things happening. Take a stock market crash, for example: if you’re fully invested in the stock market and it falls by 20%, it wipes a big chunk off your wealth – and you know it. You can be (rightly) afraid of it happening, and plan to minimise its impact – by diversifying away from just investing in the stock market, for example.
The nasty thing about inflation is that it’s gradual. Think of it like waves hitting a cliff: watch it for a minute and nothing happens, measure it after a year and you might detect 0.2mm of erosion… then suddenly, one day a huge chunk of someone’s garden crashes into the sea.
For example, say you were so scared of a stock market crash that you kept all your savings at home in a safe. Put £100 in there, and in 11 years’ time you’ll still have £100.
But because of inflation, the purchasing power of that 100% won’t be the same as it was: goods and services will have increased in price, so your £100 will buy less when you open the safe than it did when you closed it.
In fact, with inflation running at a pretty unremarkable 2% per year, after 11 years the value of your savings will have declined by… 20%. The same 20% as the stock market crash you were trying to avoid in the first place.
What is the typical rate of inflation?
To ratchet up the anger, let’s look at a real example of what inflation would have done to your savings over a period of time you’re likely to be familiar with.
Let’s say in 2016 you found a £10 note in an old wallet that had been sitting in a pocket of an old jacket for ten years. Over the intervening years, inflation averaged 2.9% per year – meaning that what you can buy with that £10 today would actually have bought you £13.28 worth of goods in 2006.
That means that in the decade between 2006 and 2016, inflation would have made you 35% poorer. That’s over one third of your purchasing power wiped out.
It might help you work up a healthy loathing towards inflation if you think of it as a tax on your savings – because it has exactly the same effect.
What causes inflation?
Inflation doesn’t happen because goods cost more to produce as time goes on: in fact, they usually get cheaper as technology improves. Depending on who you listen to it’s actually caused by increases in the money supply, pressures in the economy, expectations about the future, or plenty of other factors.
The reason doesn’t particularly matter, for our purposes. Two things matter:
- It’s been around since anyone bothered measuring for it
- Governments have no incentive to try to get rid of it
In the USA, for example, prices in 2018 are 1,903.48% higher than prices in 1800. The average inflation rate over that time has been 2.28% per year. (Again this is an example of how a number that doesn’t sound like much – 2% – really adds up over time.)
Why are governments OK with inflation? There are two main reasons:
- The opposite of inflation – deflation – is more of a threat to an economy than mild inflation. Deflation means that prices are constantly falling, which encourages people to delay purchases – meaning that economic activity is drastically reduced.
- Governments have huge debts, and inflation has the handy effect of eroding these debts in real terms.
(You’ll have seen the term “real terms” used a lot in the news, I’m sure. It’s just an unnecessarily confusing way of saying “after removing the effects of inflation”. For example, say inflation was 2% and house prices rose by 5%. You could say that house prices rose by 3% “in real terms” – in other words, after stripping out the 2% inflation.)
In the UK, the Bank of England actually aims to keep inflation running at 2%. If inflation goes significantly higher or lower than that, they’ll pull whatever levers they have available to them in an attempt to get inflation back to their 2% target.
You might think that they should target 0% inflation – in other words, just keep things as they are. But because they’re so scared of deflation, they prefer to aim for 2% so it’s not so serious if they under-shoot it for a while.
Bottom line? Because inflation has been going on for so long and nobody has much desire to do anything about it, it’s fair to assume that it’s going to continue for as long as any of us will be around to care about it.
Why do you need to be angry?
I’m a placid kind of guy, and rarely find it useful to get angry about anything. So why am I advocating getting so worked up you want to punch inflation’s lights out?
The main reason is to motivate you into action. Because of inflation, doing nothing is more costly than it seems. If you don’t grow your assets, you’re not standing still: you’re going backwards.
This is particularly the case at the moment, when it’s impossible to keep up with inflation by doing the easy, safe thing like keeping your cash in a savings account. At the time of writing, the top paying instant access savings account pays an interest rate of 1.5% and inflation is running at 2.7%.
That means that even if you had your money in the best savings account, you’d be getting 1.2% poorer every year. And most people don’t have their money in the best account – it’s probably in the same current account they’ve had for years, earning 0.5% interest if you’re lucky.
The other reason for getting angry is to make sure you don’t forget about inflation when calculating your investment returns. For example, say you put money into an investment that’s making a 5% return per year. Great! But if inflation is 2.7% (like it is at the moment), you’re only actually increasing your wealth by 2.3% after taking inflation into account.
What should you do about inflation?
Inflation is a fact of life, and there’s nothing you can do about it. The two things you should take away from this article are:
- Don’t ignore inflation when calculating your investment returns, because it’ll make things seem better than they are.
- Inflation means that by standing still, you’re going backwards. Even if you have all your savings in cash, aim to get the best interest rate you can to minimise the bite inflation will take out of your buying power every year.
What amount of inflation you anticipate is up to you, and might be based on your expectations of what you expect the economy to be like in the future. Considering that the Bank of England target is 2% and the average for the last 18 years is 2.06%, something in that range is probably a fair estimate.