August 1, 2014

Inflation

Inflation refers to a sustained increase in the overall prices for products and services within an economy. The effect of an increase in inflation is that for every pound, you will receive a smaller amount of a good or service prior to inflation.

Inherent value of a currency always varies in relation to inflation. For example, consider there is an annual inflation rate of 5%, this will mean a £1 newspaper will cost £1.05 next year.

Reasons for inflation

The specific reasons for inflation are varied, however economists broadly agree on two main threes. The first is known is cost push inflation. This is where organisations need to raise their prices in order to counter rising costs. For example, the costs of commodities may increase. The second main theory of inflation is demand pull inflation. A phenomenal increase in demand which manages to outstrip supply can result in increasing prices in order to control the demand.

Effect of inflation on investments

Inflation can affect investors in differing ways depending on the make-up of their investment portfolio. Those investing in equities shouldn’t worry too much about the effects of inflation because the earnings of a company should increase in line with inflation. However, there can be a time where downturns in the economy fuse together with an increase in costs which is a negative result for equities. Similarly, investors should always look out for high levels of inflation because an increase in revenues may be because of the inflation rather than business performance.

Those investors particularly susceptible to inflation are those within fixed income sectors. For example, imagine a bond  investment of £2,000 with a 20% yield. Upon collecting the £2,400 (20% yield), it would be wrong to consider you have made a ‘profit’ of £400. This is because inflation may have risen within the year. If inflation was at 6% for the year, your real rate of return would be 14% or rather £2,280.

Inflation and Interest Rates

Upon first glance, inflation can be seen as ‘bad’. However, many actually see it as a natural effect of a growing economy. In contrast, deflation in which there is a decreasing of prices is a worse phenomenon because it appears to be a stimulus for revival.

Inflation and interest rates are commonly mentioned in parallel with one another. This is because they have a clear relationship. For example, suppose interest rates are lowered, resulting in consumers spending more, growing the economy and producing inflation. Similarly, if the economy is growing too quickly, then interest rates can be increased to reduce spending within the economy.

Within the UK, inflation is commonly measured via two methods:

  • Retail Price Index
  • Consumer Price Index

Both of these methods are detailed in full here.