The Governor of the Bank of England says that tough monetary policy will bring inflation down from 5% to 2% over the next two years. He is dreaming. Act now to protect yourself.
The shock of inflation, as measured by the Consumer Price Index, hitting 4.4% in July (and 5% according to the Retail Prices Index), sent economic pundits into a frenzy of doom-mongering. The Governor said CPI inflation would peak at 5% in the next few months and his stern monetary policies would bring it down to 2% over the next two years.
The bosses at the European Central Bank have the same mindset. Their only idea is to keep interest rates at a high enough level to depress the economy so that inflation stays below target.
Failed to address larger issues
Inevitably, therefore, Governor King had to drone on about rising unemployment, a gloomy housing market, tough times for business and so forth.
What he failed to do is to explain how his policies would work in the longer term if we assume, as looks inevitable, that inflation rates in the booming developing markets of China, India and Brazil and Russia stay at between 5% and 10%. These economies are in a development phase where inflation is actually a necessary part of the economic landscape and where reducing it to 2% is neither feasible nor desirable. So how can we have 2% inflation while they have 6% inflation? The Governor’s only answer to that is pain and more pain.
Yet when you ask who benefits from the pain of keeping inflation down, the answer is always the same: the rich (and their banks). The poor, and people with debt - which means most of the middles classes - benefit from inflation, which is actually the only politically acceptable way of transferring wealth from the old and rich to the young and poor - a transfer that economists recognise must happen to stop the economies of the developing world becoming as moribund as that of Japan.
Two years of pain
But conventional economics says inflation must be controlled, so both the UK and Europe are likely to suffer at least two years of pain with interest rates higher than they need to be. This will result in a dip in inflation in 2009, but unless the developing market boom comes to a halt – which would mean doom for us all – it will probably then rise again.
Meanwhile, financial markets say the Governor’s strategy is a busted flush. The reason sterling has fallen 14% against the US dollar in a few weeks is that investors expect UK interest rates to be slashed as the economy hits the buffers.
The inflation genie is out of the bottle and it won’t go back again, especially since the US Federal Reserve is quite clearly setting its policy on encouraging growth at the expense of higher inflation.
Buy protection against inflation
So how can you protect yourself against higher inflation? Put some savings into inflation-linked bonds and some into shares. Both are winners from inflation.
The best inflation bond is from Leeds Building Society. Its Inflation Buster Bond pays interest at a rate of 2.25% above the annual increase in the RPI, from 1st October 2008 to end-September 2010. If you don’t pay tax, buy the Inflation Buster Bond; if you do, buy the Inflation Buster ISA where the interest will be tax-free. Both have a £1,000 minimum.
If you pay tax at the higher rate and want to save more, buy National Savings & Investments Index-Linked Certificates. These pay annual interest at RPI inflation plus 1% over 3 or 5 years and the return is tax-free. The maximum investment is £15,000 per person.
Buy shares for the long-term
As usual the press has run a series of silly season stories about putting your money into collectibles like stamps and wine to beat inflation. Forget it. These are investments that are only suitable for rich people.
The slam-dunk investment for the long-term to protect against inflation is shares, because companies raise profits and dividends along with prices.
See my selection of share investments paying 5% dividends that are likely to protect your wealth over the next 5 to 10 years.
