What do inflation, rate rises and general elections mean for UK investors?
L&G’s Richard Penny ponders future interest rate rises and how they could impact the UK...
Inflation figures are reported each month. The figure (a percentage) is usually accompanied by comments about how the cost of filling our cars with fuel has increased or decreased and whether or not the weekly trip to the supermarket has become cheaper or more expensive.
But what is inflation? Is it good or bad for our finances? We take a look:
Simply put, inflation is the increase in the price of our everyday goods and services. It is calculated using a ‘basket’ of commonly-used goods and services, the average price of which is shown through the Consumer Price Index (or CPI).
When we are in an inflationary environment, it essentially means we have the same amount of money to spend each month but, as things cost more, it doesn’t go as far as it used to – the real value of our cash is being eroded.
There are two main types of inflation: demand-pull, which is when there is more demand for goods than there is supply, and cost-push, which is when the cost of making goods increases and companies have to raise their prices in order to cover the shortfall. The former is typically a ‘healthier’ type of inflation – it usually moves in-line with a rise in employment and wages and because we have more money in our pockets, we tend to spend more. In contrast, the latter can put a strain on the consumer and therefore negatively impact the economy.
Disinflation is still a period of inflation, but prices are rising by smaller amounts than they were before. In other words, the rate of inflation is falling. Disinflation can, in some cases, suggest unemployment is rising or economic growth is slowing. It can also come about when central banks raise interest rates.
Deflation is the opposite of inflation: when the rate of inflation drops below zero and goods and services become cheaper. This may at first sound like a positive. After all, if your salary is the same but the things you want to buy become relatively cheaper, surely this would encourage spending and boost the economy? Not necessarily.
The issue is that, because the value of your cash increases, you are more incentivised to hold onto your money in savings, rather than spend it. After all, what is the point in buying something today when it could be even cheaper tomorrow? As fewer products are bought, companies’ revenues fall and this can then lead to higher rates of unemployment and a continued downturn in spending. This is known as a “deflationary spiral”.
Stagflation is when there is no economic growth and unemployment is rising, but there is still inflation in the system. In other words, your wages would be falling, but the price of goods would keep rising. Of course, this is not an ideal environment for anybody! Stagflation tends to be the result of ‘bad’ or ‘cost-push’ inflation.
Reflation essentially signifies the start of the inflationary cycle after a recession – it should not be confused with full-blown inflation and it tends to happen more gradually.
It is when the economy starts to experience stronger growth in conjunction with rising prices. It is often caused by central banks reducing taxes, printing money or lowering interest rates – in other words, by injecting more cash into the economy.
It means that, as economic growth improves, demand for goods increases, companies make more products and more staff get hired. It should also lead to higher wages as companies continue to thrive.
It also benefits the government because, as corporate profits improve and more people return to the workforce, they receive more tax revenue. The government should also spend less money as benefit payments fall.