Personal Finance: Don't let inflation catch you off guard

By Ros Altmann, September 17, 2009

Is it time to start worrying about inflation? Over the past year, inflation fears have faded and concerns have focussed on deflation dangers. In fact, the Bank of England’s latest policy of so-called “quantitative easing” — a rather fancy name for printing money — aims to fight deflation, but has potentially significant inflation risks.

I am not saying inflation is definitely about to take off, but as we look forward to next year, perhaps there is too much complacency about the inflation outlook. Investors should be aware of the risks. Inflation can dramatically damage your wealth: at just 5 per cent, it will halve the real value of your money in under 15 years. With an election looming, the government is desperate to show its economic policies have worked, so a strong recovery will be engineered at all costs. The unprecedented easing of both monetary and fiscal policy is bound to boost growth, but as the economy recovers, the authorities will be frightened to tighten too quickly. If they keep policy too loose for too long, the pound may fall and, if commodity prices increase as the global economy recovers, inflation could take off.

What will this mean? The first consequence of higher inflation will be rising interest rates, possibly early next year. Initially, savers will feel relieved, because the ludicrously low interest rates we currently have will start to return to more ‘normal’ levels. Bond investors, however, will lose money, as rising interest rates mean falling bond prices. The dangers of inflation come through over time as the real value of savings, investments or pensions falls. Inflation then turns into dreadful news for savers and pensioners. These are the very groups that were hardest hit by the dramatic rate cuts last year. On the other hand, borrowers benefit from inflation, as their debts are devalued. This is another reason why the authorities will be so tempted to take risks with inflation. The government itself is the biggest borrower of all, and the budget deficit would benefit from a dose of inflation.

How can I protect myself? Inflation-linked bonds (either gilts or corporate bonds) and index-linked National Savings, which pay interest that rises with inflation, offer good inflation protection. Gold usually acts as a hedge against inflation, while property or shares have provided some inflation protection in the past, although this is not guaranteed at all. Final salary pensions offer partial inflation-linking and buying inflation-linked annuities with a private pension can protect the real value of your pension income over time.

As we think about the coming year, it is probably sensible to consider some inflation protection, at least for part of your wealth, in case the current policy easing cannot be unwound in time. Nobody knows for sure, but perhaps better safe than sorry.

Ros Altmann is a former government pensions adviser

Last updated: 12:46pm, September 17 2009