What is inflation, and is it impacting you?
19 October 2021 Investment Academy
Let’s start with the basics: What is inflation?
Inflation is the rate at which prices rise (thus reducing your ability to buy what you’re used to). If the cost of a £1 jar of jam rises by 5p, then jam inflation is 5%1 .
It applies to services too, like having your hair cut or popping to the dry cleaners.
The market determines inflation, and in the past 18 months, COVID-19 changed our spending habits, e.g. from going less to the cinema to spending more on subscriptions like Netflix.
You may not notice inflation levels from month to month, but in the long term, these price rises can have a significant impact on how much you can buy with your money.
It’s worth noting that inflation can be difficult to predict, even for the most knowledgeable economists.
Central Banks have printed a lot of money to stimulate consumer demand, and a strategic decision is needed to keep the global economy afloat during the COVID-19 pandemic. Demand for goods and services has now strongly recovered, but the supply side now looks challenged, experiencing supply shortages (energy, labour).
How is inflation impacting our energy supplies?
On energy prices specifically, the lack of investments in fossil fuels over the last 24 months is impacting everyone’s finances. The shift to a decarbonised energy system would make our economies less dependent on energy price swings while paving the way for a sustainable world.
How is it measured?
The Office for National Statistics (ONS) keeps a record and a close eye on the prices of lots of everyday items such as toilet paper, bread, and milk2 .
This list of items is called a “basket of goods,” and it’s constantly updated.
This list adapts and changes in alignment with what the spending trends are. For example, during 2020, our spending habits changed. We no longer needed gym memberships, and items like hand sanitiser, masks and smartwatches were added to the list. It also often ends up in the news, like the current fuel crisis, where we’ve seen the price of petrol climbing well above the recent ONS data.
What is the inflation rate used for?
Inflation is used to inform a wide variety of decisions, like how much the price of pensions will rise or if the price of everyday items will rise.
It’s keenly watched by economists too. They see inflation as a sign of what’s going on in the economy.
Why is everyone talking about inflation right now?
In recent years we’ve not had to consider the impact of inflation as much as we did years ago. But since COVID-19, the global economy has taken a bit of a bumpy ride. This, hand in hand with the switching to renewable energy sources means we may be seeing more inflation fluctuations than before3 .
Is inflation on the rise?
The short answer is yes. Before the pandemic hit, inflation in the UK was around 2%, which is a percentage that the Bank of England aims for and expects.
But due to a mix of circumstances, such as Brexit, COVID-19, and a whole host of other events, the topline figures for inflation have been impacted significantly – most years, we expect a 1% increase per year, but in Aug 2021, we saw inflation spike to 3.2%4 .
It’s not fully clear if this rise is a trend (the new “normal”) or a temporary anomaly.
So, to conclude. Should we be worried?
It’s complex, so there’s no definitive answer yet.
We asked our investment team for their take and if we should be concerned:
“Central bankers and policymakers around the globe currently believe that the current acceleration in inflation is transient and will likely return to normality (which is around 2%) as we approach 2022.
But there are many risks to this consensus, driven by a prolonged energy crisis, labour shortages, and rising food prices. We’re keeping an eye on this as we consider what’s next for the markets.”
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