The UK’s inflation conundrum
The UK’s economy has shown remarkable resilience since the Brexit vote in June, but figures released by the Office for National Statistics (ONS) this week pertaining to the cost of living will have concerned some consumers. Inflation, as measured by the Consumer Price Index (CPI), rose to 1.2 per cent for November, which represents a 25-month high, and a significant climb from October’s corresponding figure of 0.9 per cent.
As a further reference to indicate the extent of this upward shift, CPI was just 0.3 per cent for the month of May 2016 (ie: prior to the EU referendum), while it stooped to -0.1 per cent – or ‘deflation’ – as recently as October 2015. The biggest contributors to the CPI increase last month were said to be the rising costs of fuel, clothes and ‘cultural and recreational goods and services’, and the think tank IHS Global Insight expects that inflation will trend considerably higher in the coming months as a result of the decline in the value of the pound sterling.
Inflation, interest rates and currency value
According to economic theory, inflation and currency value have an inverse relationship, other things equal. This means that as the CPI rises, so the pound should devalue. But in reality, there is a third, inextricable member of this relationship: the interest rate. And early responses to the release of this inflation data have actually seen the pound strengthen somewhat.
This is because the most powerful tool the Bank of England has at its disposal to halt rising inflation in its tracks is to raise interest rates, and although we are still below the Governor Mark Carney’s inflation target of 2 per cent, forecasts of this being reached as early as Q1 2017 seem to have, at the very least, quashed the prospect of any further cuts. And should the Bank decide to increase rates, the superior yield on bonds encourages global investors to send their money to the UK, which would in turn give sterling a boost.
So is this what we should expect in the short term?
Should rates go up, and the pound subsequently strengthen as per the theory outlined above, then this will of course reduce the inflationary pressures being put on our import-heavy economy, and thus provide a natural stabiliser for the CPI.
Yet this is far from a formality, and there a number of other factors involved. First of all, the general economic uncertainty that looks set to shroud the UK in the early years of the post-Brexit era is likely to provide a deterrent on any increase to Bank of England rates. Indeed, in a difficult climate, it is perfectly plausible that Carney could prioritise growth, and maintaining impetus within the economy, even if it means letting inflation move beyond his 2 per cent target.
And to exacerbate the issue at household level, the increase in the price of Brent crude oil - as a result of an agreement struck among OPEC members in October to reduce production – will exert further pressure on prices across the board.
So what would this mean for consumers?
No one can predict what the future will hold with complete certainty, and as the UK enters the new territory of departing from the European Union, any number of outcomes are possible. But it does appear likely that, in the short run, inflation will continue to rise, and, if this occurs in the absence of an increase in interest rates, it will almost certainly squeeze savers, as their chances of gaining real returns on risk-free investments will diminish.
But just a little bit further up the risk spectrum sits peer-to-peer lending, and with a risk profile generally considered to be a midpoint between savings and stocks and shares, it offers an excellent opportunity to earn positive inflation-adjusted returns – particularly with the advent of the new Innovative Finance ISA, which brings a significant tax benefit into the equation.
A new financial landscape
IHS Global Insight anticipates that inflation could breach the 3 per cent barrier before the end of 2017, which represents a seismic shift in the inflation landscape when compared with the past 18 months. When stacked against historical figures, CPI statistics in the region of 3 per cent are not actually that high. But what might potentially set such figures apart in a relative sense would be if interest rates remain at record lows.
Yet while such a trend would present clear challenges, all is by no means lost. For savers in particular, the key takeaway is that they will need to consider, and thoroughly research, alternatives which exist in the wider mainstream, and thus find new ways of making their money grow. In doing so, such external financial headwinds can be successfully negotiated.