The latest inflation figures came as a surprise for the markets and the Bank of England. Based on the government’s favoured yardstick, the Consumer Prices Index (CPI), prices rose by 2.9% in the year to May, the highest level since June 2013. The Retail Prices Index (RPI), which is no longer an official statistic, recorded a 3.7% annual increase.
The 2.9% figure was above the level which the Bank of England had expected inflation to peak in the fourth quarter of this year. It is also comfortably above the pace of earnings growth, which the most recent data showed to be running at 1.7% (excluding bonuses). That gap of over 1% implies a squeeze on consumers, who have traditionally been the mainstay of the economy. If you seem to have less to spend in recent times, now you know why.
What happens next?
In the short term the experts, including the Bank of England, see inflation staying above the Treasury’s 2% target. The question of how much higher it will go provokes differing opinions, depending largely upon forecasts of whether the pound will weaken further in response to Brexit negotiations and UK political machinations. It will only take another 0.2% increase in the CPI for Mr Carney to have to write a formal letter to the Chancellor explaining why the Bank has missed its inflation target. He has probably already prepared a draft that refers to the fall in the pound from $1.50 just before the referendum to around $1.27 now.
In more “normal” times, the Bank would react to rising inflation by pushing up interest rates. However, as the graph above shows, we are a long way from normality. The last meeting of the Bank’s rate-setting committee voted 5-3 to hold the base rate at 0.25%. The level of dissent subsequently prompted what looked like a public disagreement between Mark Carney and the Bank’s chief economist, Andy Haldane, about when rates should rise. In practice, their differences were more nuanced, but the money markets are now pencilling in a rate increase for next year, rather than 2019. When it does arrive, that will be the first rate rise since 5 July 2007. Nobody is anticipating a rapid escalation once the increases begin. After over eight years of a sub-1% base rate there are concerns that borrowers of all kinds, from homeowners to the government, could not cope with a sharp jump in their interest costs.
The rise in inflation means that you may need to review life cover and regular savings, including pension contributions, to make sure their buying power is maintained. On the investment front, the combination of rising inflation and miniscule interest rates means that holding a larger cash reserve than necessary is generally to be avoided.
After a period when inflation virtually disappeared, it is back with a vengeance. If your financial plans have not taken account of inflation, now is the time for a review.