Are we going to see the return of inflation?

15/05/2020

The coronavirus pandemic has had a dramatic effect on the global economy. Around the world economic activity has dried up. Fewer consumers are buying and fewer companies are investing.

COVID-19 Information hub

For M&G’s latest perspectives on how COVID-19 is shaping markets visit our information hub.

i-icon

Read more

Looking for financial advice?

If you are unsure about the suitability of any financial product or service we strongly recommend you speak with a financial adviser.

handshake Find a financial adviser today

Glossary

For explanations of the investment terms used throughout this article.

View the glossary

In March 2020, the Consumer Price Index (CPI) rate of UK inflation, which measures annual changes in the prices of goods and services bought by households, had declined to 1.5%. Not only is this below the Bank of England’s 2% target, but the Bank expects it to fall to around 0% by the end of 2020.

Why inflation may first fall

There are a number of factors driving down inflation. The social lockdown to help combat the spread of the virus is seeing us having to stay at home, meaning we have generally been spending less. As elsewhere around the world, we have also been driving and travelling far less.

This has contributed to a profound decline in global demand for oil. On 20 April 2020, the price of crude oil (as measured by the West Texas Intermediate benchmark for US oil) fell below zero for the first time in history. With such reduced demand for oil, and concerns over storage capacity, we saw oil producers prepared to pay to have the commodity taken off their hands.

The price of oil has been a historic bellwether for the health of the global economy, given its pivotal role in modern life, from transport to food production to chemicals. Lower oil prices should feed into lower costs of production for a wide range of goods, pushing down inflation.

Inflation is also being forced lower by the decline in demand across the economy. Despite unprecedented support from the UK government to help workers and businesses, job security and consumer confidence has collapsed. Economic uncertainty and the threat of unemployment leaves many less willing to spend, and businesses less willing to invest in capital.

Why inflation could make a comeback

Many of the drivers of lower inflation are temporary in nature, so long as the economy is on lockdown.

Unless the damage done to the economy ends up being lasting, we would expect a pick-up in spending once there is some resumption of normality. After all, there is likely to be pent-up demand from consumers for a range of purchases and companies might be expected to sign-off on delayed investments once they feel there is more certainty.

Depending on how much demand is pent-up, and how willing consumers and businesses are to part with their savings when we start to emerge from the crisis, the rise in spending could drive inflation higher. After all, more money will be chasing the same (or potentially fewer) goods and services.

Over the long term, there are worries about other possible inflationary pressures. Prices can also go up because there is less supply of products. The ongoing chaos caused by the crisis is seeing huge disruptions to trade, and companies going bust. This could have the effect of constraining the supply of goods and competition in the global economy, contributing to higher prices at checkouts.

Greater government spending could also contribute to higher inflation, with more cash being put towards recovery. In May, UK chancellor Rishi Sunak introduced ‘bounce back loans’ for small businesses of up to £50,000 – one of many measures that will keep money flowing in the economy. Higher government spending, in addition to lower interest rates – the Bank of England cut the UK base rate to an all-time low of 0.25% in March – would both be expected to add inflationary pressure over time.

Protection from rising inflation

Due to the heightened degree of uncertainty in global markets, it is difficult to forecast the outlook for inflation with any certainty. Nonetheless, it is worth considering the possibility that inflation may rise to levels that have historically been more ‘normal’.

After all, the past decade has seen exceptionally low inflation. As recently as the mid-2000s, before the global financial crisis, UK CPI was regularly ticking along at 3% a year.

If you think inflation could go up in the long term, it is worth asking whether your savings and investments could be affected. After all, you need your investments, and the income from them, to keep pace with inflation to maintain the value of your buying power.

Investments that offer the potential to rise in value with inflation (or deliver an income that rises with inflation) could protect you from the risk of this. As well as inflation-linked bonds, whose income coupons and value will track a measure of inflation, company shares and property assets also have the potential to offer protection against the threat of rising inflation over time.

If you are concerned about higher inflation, you may wish to consider seeking financial advice. Speaking to a financial adviser can help you define an up-to-date investment plan, unique to your goals and needs.

Please bear in mind that M&G is unable to give financial advice. The views expressed here should not be taken as a recommendation, advice or forecast.

Of course, all investments carry the risk of loss. When you're deciding how to invest, it's important to remember that the value of investments will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.