Inflation headlines have been dominating the news for the majority of 2023 so far, but what does inflation really mean, and how does it impact the performance of clients’ investments?
Inflation is a crucial economic indicator that measures the general increase in prices over time. It impacts various aspects of the economy, including consumer purchasing power, central bank policies, and financial markets. Let’s explore the different inflation measures used worldwide, central bank inflation targets, recent developments in inflation, and the market impact of rising inflation.
Inflation Measures
In most countries, inflation is measured using indices that track the prices of a basket of goods and services. These indices typically include some housing costs. In the UK, the consumer price index (CPI) has replaced the retail price index (RPI) as the most commonly used measure. The CPI consists of goods comprising 47% of the basket and services comprising 53%. Food represents 11% while energy and rents each account for 8%.
The main difference between the CPI and RPI is the inclusion of mortgage interest costs in the latter. In June, RPI inflation stood at 10.9%, significantly higher than the 7.9% shown by the CPI. This disparity demonstrates the influence of housing-related expenses on inflation measurements.
Central Bank Inflation Targets
Central banks play a crucial role in managing inflation by setting targets and implementing monetary policies. The Federal Reserve (Fed), European Central Bank (ECB), and Bank of England (BOE) all have inflation targets of 2%, but there are some differences in how they are formulated.
The Fed has a dual target of achieving full employment and stable prices. In 2020, it also announced that it would tolerate an inflation overshoot following a prolonged period of undershoot. The BOE and ECB, on the other hand, solely focus on achieving their 2% inflation targets in the medium term.
In response to increased inflation pressures, central banks are likely to become more tolerant of an inflation overshoot and down the road may even consider raising their targets to 2.5-3%. At present, however, they remain steadfast in their desire to bring inflation back down to 2%.
Recent Developments
Recent developments have seen a significant moderation in headline CPI inflation across different regions, although the UK’s decline has been comparatively small. In the US, headline CPI inflation has fallen from a high of 9.1% to 3.0%, while the Eurozone has witnessed a decrease from 10.6% to 5.5%. In the UK, inflation has dropped from 11.1% to 7.9%.
Core inflation, which excludes volatile food and energy prices, is the metric central banks typically focus on. Despite the moderation in headline rates, core inflation remains relatively high in the US and Eurozone at 4.8% and 5.5% respectively and in the UK is still as high as 6.9%.
Outlook
Looking ahead, headline inflation is expected to continue moderating as energy and food inflation slow down. However, the key concern for central banks and markets is how quickly underlying inflation pressures ease. While core inflation is projected to moderate, it is likely to remain well above 2% in all three regions for at least another year or two.
Inflation pressures are particularly entrenched in the UK due to a tight labour market that has kept wage growth higher compared to other regions. Private sector wage growth reached 7.7% in April. Additionally, the impact of Brexit adds to the cost pressures faced by the UK economy.
Market Impact
The ongoing worries about inflation’s trajectory have prompted central banks to raise interest rates. The unexpectedly high inflation and wage data in April and May led market analysts to revise their forecasts for the peak in UK rates to as high as 6-6.5%. However, the better than forecast June numbers have led to the expected peak slipping back to 5.75%.
This has all led to UK mortgage rates rising sharply and gilt yields have revisited the highs seen in last October’s mini-budget. Higher inflation is generally seen as bad news for holders of conventional bonds due to the capital loss incurred as yields rise. However, for equities, higher inflation does not necessarily spell disaster.
The impact on equities depends on the level of inflation and whether it triggers monetary tightening and a slowdown in economic growth. Unlike bonds, which have fixed coupons and provide no inflation protection, higher inflation can boost company revenues and earnings/dividends. Consequently, there is no automatic reason why higher inflation should lead to a de-rating of equities.
However, historically, equities have performed reasonably well when inflation remains below 3%. Once inflation exceeds this threshold, triggering a more aggressive monetary response, equities have encountered challenges.
Cash Accounts
Cash accounts may currently appear attractive due to their higher yields and lower risk, especially for clients who experienced the historic bond movements of the previous year. However, it is important to consider certain factors.
Firstly, inflation rates are significantly higher than the interest rates offered by savings accounts, leading to a loss of purchasing power in real terms. Secondly, cash accounts only provide yield without any potential for capital growth or loss, and lastly, the rates on cash accounts are subject to fluctuations based on the current interest rate environment, making them potentially unsuitable as long-term investments.
Conclusion
Understanding inflation measures, central bank targets, recent developments, and their market impact is crucial for comprehending the dynamics of inflation and its effects on the economy. Inflation measurements, central bank policies, and market reactions are intertwined, shaping economic outcomes and investment decisions. As inflation remains a key macroeconomic factor, ongoing monitoring and analysis are essential for investors to navigate this complex landscape successfully.
This communication is designed for informational purposes only and is not intended as investment advice. These investments are not suitable for everyone, and you should obtain expert advice from a professional financial adviser. Please note that the content is based on the author’s opinion at the time of writing/publish date. Our views and opinions regarding certain investment themes and topics can alter over time as the macroeconomic background changes and other industry news is made publicly available, this is not intended as investment advice.
Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise, and investors may get back less than they invested.
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