By Luke Bartholomew

 

From haircuts to heating bills to the weekly household shop, we’ve all felt the effects of inflation in recent months as the increase in the cost of living has jumped from the low rates we’ve enjoyed for years to a current rate of 6.2 per cent.

With the energy price cap increasing this month, we can expect a further inflation shock with an eyebrow-raising jump to more than 8%. The essential questions now are: What’s causing prices to rise? How long will this last? What can people do to protect their savings and investments?

We’ve just come out of a long period of price stability with UK inflation staying broadly around the Bank of England’s 2% target for years. Globalisation means we’ve enjoyed increasingly cheaper goods, produced in countries where labour cost less.

Take the price of a TV, a pair of shoes, a bed – all have fallen considerably in real terms over the years. But Covid and lockdown disruptions have made moving raw materials and finished products around the world much more difficult, so we’ve seen disruptions as production processes and supply chains have broken down.

More recently we have seen huge disruptions to oil and gas markets, with Russia’s invasion on Ukraine and the associated Western response causing further supply issues in what were already very tight energy markets.

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Economists expect many of these pressures to eventually ease over the course of the next couple of years as supply chains get up and running once again, oil and gas production ramps up, and governments increase their energy storage capacities. But in the meantime, there is going to be a period of much higher inflation than we are used to and an inescapable squeeze on the cost of living.

In response, the Bank of England has increased interest rates from historically low levels, and more rises are likely to follow. Frankly, there is little the Bank can do about global supply challenges and rising commodity prices. But it can help to "cool" the inflation pressures building in the domestic economy by putting the brakes on borrowing and spending by both consumers and companies.

With unemployment low and the jobs market weathering the end of furlough and Omicron extremely well, wage growth is likely to pick up. Moreover, with inflation so high, workers will be keen to protect their incomes by demanding wage growth that matches price growth.

But with UK productivity growth so weak, there is a limit to how much wages can grow without causing further inflation down the road. If every manufacturer, service provider and business has to pay staff more, prices for goods and services will inevitably rise to cover this, spurring inflation on. Policy makers want to avoid this wage/price spiral.

Government policy also has an important role in managing inflation expectations. The minimum wage will rise in April by 6.6% and a new public sector pay settlement is also due, with one civil service union calling for a 10% rise. The public sector employs 5.7 million people in the UK, so its pay levels will have implications for the private sector. A rise strictly in line with inflation is not going to happen, so there will be outcry about the cost of living squeeze.

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But perhaps ironically, the economic weakness that higher inflation brings should, in part, help to turn the tide against inflation. As real incomes are squeezed, spending should slow, cooling the economy and inflationary pressures. So as long as policymakers are able to stop inflation expectations moving higher through proactive interest rate increases, long-term inflation should not be a threat.

But with inflation set to rise further in the short term, plus interest rates at extremely low levels, where can people save and invest to prevent their money being eroded? Last year there was a huge move to cryptocurrencies as people decided this was a new way to store value and make exciting returns. Bitcoin and Ethereum, plus many other cryptos, made extraordinary gains.

However, the crypto crash in January wiped a third off values and made buyers wary, so these assets have not provided much protection against inflation. To protect the value of your money, it is worth considering the benefits of diversification – investments including real estate, commodities, emerging markets and some emerging-market bonds. Although gold is a traditional hedge against inflation, it had a disappointing 2021, but may perhaps perform in the year ahead.

We can now appreciate how much we took for granted that long, stable run of around 2% inflation. As Alan Greenspan once said, the definition of price stability is not having to think about changing prices. Well, we are certainly having to think about them now.

Luke Bartholomew is senior economist with abrdn.