Inflation: friend or foe?

Jonathan Wright
Jonathan Wright
Fidelity Personal Investing9 February 2018

Volatility has returned to the markets this week with a vengeance on inflation fears and the realisation that this could lead to interest rates rising faster and higher than previously expected. Last night the Dow Jones Industrials Average fell by more than 1,000 points for the second time this week, leading to further losses in Asia, Europe and at home. So what impact does inflation have on the markets and should we really fear it?

Over the past year investors in equities have become accustomed to calm markets. The Vix volatility index, which shows the market’s expectation of market gyrations, has been relatively flat throughout 2017, ending the year at its lowest point on record. That changed on Monday when it briefly shot to its highest level since the 2015 Chinese currency devaluation.

What may be surprising for some is the cause of this volatility, which is actually positive economic news coming from the US. Last Friday, jobs data showed a better-than-expected increase in the wages of American workers. While this will be welcomed by millions in the US, it raises the expectation that the US Federal Reserve will now increase interest rates more quickly than anticipated to combat a potential rise in inflation as Americans loosen the purse strings. That’s bad news for equity markets for a couple of reasons. It increases the cost of debt for businesses, and so reduces their profitability, and it makes alternative investments, such as bonds, relatively more attractive. And that’s before we consider the impact on consumers as individuals see the cost of funding their mortgages and credit card debt go up.

Over on this side of the Atlantic, the Bank of England’s Monetary Policy Committee announced yesterday that interest rates would remain at 0.5% - which is still by historical standards extremely low. However they indicated that the pace of interest rate increases could accelerate if the economy continues to improve at the current rate.

The Bank believes the era of falling real pay (that’s wages minus the rate of inflation) is coming to an end. It noted that there were signs of pay growth returning in the UK, against a backdrop of low unemployment. The current rate of unemployment is the lowest since 1975 at just 4.3%. The UK economy is also picking up and the Bank has raised its growth forecast to 1.7% this year, from its previous estimate of 1.5% made in November. This is all good news, but a sign that the Bank of England may also be changing its focus from supporting growth to tackling inflation.

Inflation - the increase in the prices of goods and services - can be both your friend and your foe. It all depends on how much you have of it and whether you’re a saver or a spender. A little inflation is a good thing. It’s a sign of an improving economy and it means that your debts - providing your income rises in line or above the rate of inflation - will reduce over time in real terms. Those that bought a house in the 1970s will know first-hand how the value of their mortgage debt decreased in real terms as their wages increased. Governments also welcome some inflation as they see the value of their borrowing reduce too.

However it’s a different story for savers, or those on a fixed income, who experience prices rising faster than their income. If you’re in that situation, it’s worth remembering that when inflation does start to rise, especially over the Bank of England’s preferred rate of 2%, the main tool the Bank has to dampen down inflation is to raise interest rates.

That’s why savers will be pleased to hear the Bank of England say rates would need to rise “earlier” and by a “somewhat greater extent” than they thought at their last review in November. Some economists believe the next rate rise could come as soon as May.

So what have we learned this week? Firstly, volatility has returned and those invested in the stockmarket can expect to see the price of their funds and shares fluctuate more widely than they have seen in the recent past. We have also seen how just the prospect of rising inflation has spooked markets in the US and the knock-on effect that has had on world markets. Like it or not, global markets are inter-connected. Finally we can expect interest rates to rise this year, perhaps sooner than we might have thought. But should we fear any of this?

Not necessarily. Interest rates have been at record lows for the last ten years so we shouldn’t be surprised that they are returning to more normal levels. The economy is finally improving after unprecedented action had to be taken after the financial crisis and that is a good thing.

For more on this week’s market corrections, check out the latest MoneyTalk Podcast where Fidelity’s Tom Stevenson puts the latest volatility into perspective.

Important information

The value of investments can go down as well as up so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.