Inflation on the rise? This chart shows the damage it could do

UK inflation has hit its highest level in almost three and half years.

The UK’s Office for National Statistics said yesterday that the consumer prices index (CPI) rose to 2.3% in February, up from 1.8% a month earlier.

It took the rate above the Bank of England’s (BoE) 2% target and may exceed 3% later this year.

Rising inflation increases the pressure for interest rate rises. It is also a threat to the value of money. The chart below explains this.

Inflation erodes the value of savings over time as it reduces spending power. This means the same £1 in a year buys you less than it would do today. Inflation can explain why a Mars bar costs 60p today, but cost 26p in 1990¹.

The chart shows how the real value of £100 can deteriorate over time, based on two rates of inflation – 1% and 5%.
With a consistent 1% inflation rate for 20 years, £100 would shrink to £82. But make it a rate of 5% and £100 would be worth a mere £36 in real terms after 20 years.

• How to prepare your portfolio for inflation

What next?

In August 2016 CPI inflation was at just 0.6%, underlining how rapidly price pressure has built in recent months.

Azad Zangana, UK and European Economist at Schroders, said: “Inflation has been rising steadily for some time, mainly due to the negative impact of the recent fall in global energy prices dropping out of the annual comparison.

“However, the impact from the fall in sterling is now also feeding into consumer prices, which is set to squeeze household finances over the course of this year. We forecast inflation to rise through 3% in the coming months, before peaking around the end of the summer, and then steadily coming down to around 2% over 2018.

“For the BoE, the latest figures will be disappointing. Inflation is likely to overshoot the Bank’s forecast and could persuade rate-setters to consider raising interest rates later this year. Indeed, outgoing Monetary Policy Committee member Kristin Forbes voted to raise interest rates at the last meeting, and could have more support over the coming months.

“We expect the Bank to hold fire for now as the rise in inflation is not being matched by higher wage inflation. As a result, the real disposable income of households is falling, which should reduce demand in the economy and therefore inflation in time. We doubt the BoE would want to raise interest rates at a time when household finances are being squeezed.”

The potential effect on stockmarkets

Equities can provide some shelter at times of inflation: stock prices may rise if the companies can pass on price hikes to customers. These price increases may allow companies to raise dividend payments more rapidly.

Inflation can be more helpful to certain stockmarket sectors.

Marcus Brookes, Head of Multi-Manager at Schroders, had expected a sharp pick-up in inflation a year ago and began preparing.

He said: “Our portfolios have benefitted from rising inflation, as we predicted. We invested in areas that typically benefit from a generalised rise in prices, such as commodities, financials and cyclical companies – those that are more profitable as the economy picks up.”

Cyclical stocks are those most sensitive to swings in the economy.

Inflation is also rising in Europe. James Sym, European Equities Fund Manager, last month said there was evidence that a pick-up in inflation was “becoming embedded and not just the commodity-driven spike that many commentators expect”.

He expected European telecoms, insurance and consumer stocks to benefit. Read the full report here: Which sectors could benefit as inflation heats up?

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