Listen to City economists and bankers and you’d think inflation was public evil number one, ahead of even Al Qaeda.
The truth is more complicated - inflation is both your friend and your enemy, but there are ways of turning this enemy into a friend. Around the world inflation is on the up. In China it’s over 8%, in India over 6%, in the US and Europe over 3%, in the UK over 4%. Rising fuel and food prices mean headline inflation rates are sure to rise further in the next few months.
This is bad news. Your earnings aren’t rising as fast as the prices of the stuff you buy. So your disposable income is squeezed. But this is just one of the effects of inflation. Other features are actually helping you out.
Inflation shrinks your debts
For a start, consider the effects of 4% inflation on your debts. If your mortgage and other debts total £100,000 then over the last year the real cost of repaying those debts has shrunk to £96,000. If inflation were to run at 5% for five years, the real value of a £100,000 debt would fall to £78,000. So long as your earnings rise roughly in line with inflation, this is a win for you and a loss for the lender.
I can tell you this works because back in the high-inflation 1970s, over a five-year period the real value of my mortgage fell by two-thirds. My earnings rose in line with inflation, so even though the price of my house also only went up in line with inflation, I was still massively better off and could afford to move to a larger house with a bigger mortgage.
The people who lose from inflation are the rich, because rich people hold lots more cash than the rest of us. And if property prices lag behind inflation, the rich lose again – but if you have a big mortgage, your winnings from the shrinkage of your debt outweigh that.
So broadly, inflation transfers wealth from the old and rich to the young and poor, which is a pretty good recipe for keeping an economy moving (young poor people spend more of their disposable income than old rich people).
That’s why inflation is not just bad news.
Get inflation working for you
But inflation IS bad news as regards your own savings if you don’t move your money into things that keep pace with it. Over the long run, interest rates on bank deposits usually lag behind inflation, and fixed interest investments also get hammered by persistent inflation.
In fact the only assets that cope well with inflation over extended periods are property and shares. Over the past century shares have produced average returns of 5% on top of inflation, while cash deposits have produced just 1%.
Companies can and do pass on price increases to their customers and inflation boosts the value of their assets. But inflation usually comes with more uncertainty – about the economy and life in general – and that means share prices tend to get more volatile and the stock market is even more of a rollercoaster ride.
There’s an easy way to turn this to your benefit: start a regular savings plan into one or more stock market funds. The simple maths works to your advantage: your fixed monthly saving buys more investments at low than at high prices, and over a period of years this is sure to mean you end up with a higher average rate of return*.
Use a self-select ISA and spread your money across several funds to create a balanced investment plan from day one.
See my four-fund ISA savings portfolio
Inflation could be a feature of life for many years to come if the developing economies with over 3 billion people (China, India, South America, South East Asia) continue their recent pace of growth. It may take a year or two before the politicians and central bankers of Western economies abandon the idea that we can keep our rate of inflation way below that of the rest of the world. But sooner or later a bad idea does get junked - especially if it has adverse political consequences.
*Actually, what it means is that your average cost per investment unit will be below the average market price over the savings period, and the effect of that is to increase the average rate of return you get on your money.
Important risk warning - please read
The value of your investment and the income from it can go down as well as up and you may not get back a significant proportion of your investment. Past performance is not an indication of future performance. If you are in any doubt as to the suitability of an investment, you should seek independent financial advice.
