What is inflation?

Inflation is most likely to be tested in the CII’s R02 or AF4 exams. Here, we remind ourselves of what inflation is, how it is measured, how it can be controlled and its impact on investors.

Over the course of 2021, UK Consumer Price Inflation (CPI) rose from 0.7% to over 5%. Economists state Brexit and the Covid-19 pandemic as the root causes. Although it is hoped that both of these shocks may be temporary, that is of little consolation to those who are currently finding it harder than ever to make ends meet.  

What is inflation and how is it measured?

We know that inflation is the rise in prices over a period of time.

There are a number of different inflation measures – for many years the Retail Prices Index (RPI) was used but in 2003, it was changed to the CPI as this was deemed to be more EU-friendly for comparison purposes.  However, RPI is still published and is still currently used for index-linked gilts.

In 2017, the CPIH (the CPI including owner occupiers’ housing costs) became the lead measure of inflation used by the Office for National Statistics (ONS); owner occupiers’ housing costs are not included in the CPI so CPIH is the most comprehensive measure of inflation although, other than including these costs, CPIH is identical to CPI.  

How do we control inflation?

The Bank of England has an inflation target of keeping the CPI at 2%. When the CPI is more than 1% outside of this target in either direction, the Bank’s Governor must send an open letter to the Chancellor explaining how this has come about and how the Bank intends to rectify the situation.

The aim of monetary policy is to stabilise the economy by controlling the supply of money and interest rates.  By increasing the short-term interest rate, monetary policy is said to be tightened to bring inflation down. Longer-term interest rates should rise, we have less money to spend, businesses invest less and borrow less. Those relying on the interest from investments obviously benefit, providing they’re not tied into a fixed interest product.

Money markets respond rapidly to changes in interest rates. Sometimes changes are magnified, for example, if the Bank cuts interest rates for the first time in a while, the markets may feel that this is to be the first of a number of cuts and longer-term interest rates will fall. The opposite is true where the Bank increases the short-term rate after a period of reductions or stable rates.

Changes to interest rates don’t impact inflation immediately, they take time to filter through the economy. A change in interest rates today is likely to reach inflation somewhere between one and a half to two years ahead. 

Impact on investors

For those with variable rate deposit accounts, the rate will tend to follow the direction of inflation. As inflation falls, interest rates fall and vice-versa. A real positive return – i.e. a return in excess of inflation and tax, can only be achieved if the rate of interest is greater than the rate of inflation and any tax that may be due. Inflation will reduce the purchasing power of the investor’s capital.

As the coupon on fixed interest investments and their nominal value remains the same over time – unless they are index-linked – inflation erodes both the interest and the capital.

The market value of fixed interest investments is influenced by changes in inflation and interest rates. For example, with the rate of inflation currently high, interest rates have been increased.  This impacts the prices of fixed interest investments as better rates can be earned elsewhere so their prices fall.  If the rate of inflation is expected to fall because of falling interest rates, prices of fixed interest investments rise as the coupon payable becomes more attractive.

For those invested in equities, successful companies tend to increase their profits as inflation rises which then results in higher dividend payments. Falling inflation tends to coincide with falling demand and falling profits.

What next?

The Bank of England has stated that they expect inflation to rise to over 7% in spring 2022. Then they expect it to fall back during the rest of this year and next. They believe it is unlikely that the prices of energy and imported goods will rise as rapidly as they have done of late, meaning that the rate of inflation will decline. They expect to be much closer to their 2% target in two years’ time.

Grab the resources you need!

If you’re studying for your CII R02 exam, and you want to give yourself an edge, grab our free taster to try out one of Brand Financial Training’s resources for yourself.  Click the link to download the R02 mock paper taster now!

Alternatively, you can download the taster for AF4 if you are preparing for that exam.