Mark Carney’s speech on 7 August has effectively sanctioned the Bank setting a higher inflation target for the UK.
It also signalled that interest rates are going to remain at near zero levels for many years to come, guaranteeing a steady erosion of any cash you hold.
Why inflation is going up
In a nutshell, we are going to see higher inflation as it is only way that the government can deal with its escalating debts. The UK started this policy in 1945 in response to what Keynes then described as the 'Financial Dunkirk' that our public finances were left in after the war. The UK debt to GDP ratio had reached 237 per cent. The UK managed to get its debt burden down to 50 per cent of GDP within 25 years. During that time, it never paid off a penny of debt, it primarily inflated it away.
But if the current government is going to use inflation to deal with its debts, who are the counterparties that are going to lose out? I'm afraid that is likely to be any person or organisation (e.g. pension fund) with accumulated wealth. However some will lose more than others.
Cash - a definite loser
Keeping your wealth in cash is definitely going to lose value over the coming years. Indeed, if inflation averages 4-5 per cent over the next three years, you'll lose one tenth of the purchasing power (after tax and assuming the best interest rates of around 1.5 per cent). Even using a fixed rate savings account is not going to help much and the government has long stopped offering index-linked savings at NS&I.
Gold - lost its lustre
Many believe gold is the ultimate asset to hold in periods of inflation. My analysis shows it is not a very good inflation hedge. Gold is more a safe haven asset. Some of those periods of economic uncertainty have also accompanied periods of extremely high inflation, hence the correlation. However, the lower levels of inflation that we are likely to see in the UK in the near future are unlikely to directly impact the gold price.
It should also be remembered that gold prices have risen greatly over the past decade and many are now arguing the bubble has burst. Whether they are right remains to be seen, but be aware that gold is not a simple inflation hedge.
Bonds - the touch paper has been lit. Stand well back.
The prices of bonds have been increasing for three decades, as the yields have been declining. They cannot go much lower than they are today. At some point soon that trend is going to turn. When it does anyone holding bonds is going to suffer a capital loss.
The historical data on bonds and inflation support this view to. According to London Business School's Elroy Dimson and colleagues, for every 10 per cent gain in inflation, the value of bonds on average decline 7.4 per cent. Inflation linked bonds seem no alternative either, as the prices of them are so high that yields are currently negative.
Property - enjoy the pre-election boom
Property generally has a small negative correlation with inflation. However, probably a better description might be to say it is not correlated. What drives house prices most is availability of credit. The government has decided that to try to get re-elected it needs to foster a housing boom to boost the economy and create a 'wealth effect'. That is why we are seeing such schemes as Funding for Lending and the offer of 95 per cent loan to value mortgages, with the government throwing in 20 per cent.
The effects of these are already being seen in higher house prices. This trend will continue for a few years irrespective of what inflation does. However the bigger issue of affordability is not being sorted out. Wages are not rising with inflation. (They are barely rising at all). Also when – not if – interest rates finally rise, there will probably be a major correction in prices. The size of that depends on the size of the interest rate hike and how long into the future that happens i.e. how effective inflation has been in the interim in eroding mortgages.
Shares - the best bet of a band bunch?
Currently shares are near all-time highs. However, if you look back over recent history, you'll see that pretty much every time inflation has gone above 4 per cent for a while, they have either gone down or sideways at best. Therefore there has to be risk that if inflation does start to creep back over this level (which is what the BoE appears to be targeting now), we could see a correction.
Having said that, what drives share prices now is the same as house prices: politics and central bankers. In the past (until 2007), whenever inflation went up, interest rates were normally increased to rein back in inflation. That mechanism no longer applies in the current permanent low interest rate world. Given that, it is likely that for as long as liquidity is being created by central banks, shares will continue to do well.
In addition to capital values, it must be remembered that the main yield from shares is dividends and they have a good record for increasing in line with inflation. However, nothing is as simple as this. One day interest rates will rise and all assets, including shares, will then probably have a major correction.
Finally, I'd like to highlight the stark conclusion that Elroy Dimson and colleagues came to recently:
'Inflation erodes the value of most financial assets.'
Pete Comley's book 'Inflation Tax: The Plan To Deal With The Debts', is available online from various retailers. You can read the first chapter for free at: http://www.inflationtaxbook.com.