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Goldilocks and inflation – the lessons for investors

We explain how central banks try to get inflation just right and what this could mean for investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

The recipe central bankers follow to try and keep the economy at just the right temperature has the ring of Goldilocks about it.

If interest rates are kept too low the economy could run too hot, and prices might spiral upwards.

On the other hand, if interest rates are pushed up too quickly the economy could get too cold, potentially putting the recovery on ice and causing unemployment to spike.

A 2% inflation target is often considered just right, as long as the economy also keeps growing.

Where are we now?

Inflation is expected to rise to more than double the 2% target by the end of the year. The recovery also seems to be cooling due to a combination of supply chain issues, labour shortages and energy price surges. With Covid-19 infections rising again, an economic fairy tale seems increasingly out of reach.

The most recent inflation figures for September came in a touch lower than August at 3.1%. That was partly due to the artificial blip from last year’s Eat Out to Help Out scheme dropping out of the figures.

Despite the lower reading, there’s still a growing expectation that the Bank of England’s Monetary Policy Committee (MPC), which is in charge of setting interest rates, will move relatively quickly to raise rates.

At the most recent meeting in September, the MPC was unanimous in its decision to hold interest rates at a record low of 0.1%. However, it did say it was likely rates would probably have to rise towards the end of the year.

Financial markets have largely priced in a rate rise by the end of 2021, followed by further rises next year. But even if the Bank of England does raise the base rate by a few notches in the months to come, it isn’t expected to go beyond 1% in the near future.

When we last heard from them, central bank policymakers still believed the current spurt of inflation would be temporary. However, there are some signs it could stick around for longer than was previously forecast. But it’s still expected to ease off as pandemic supply chain pressures finally ease.

How does this compare to history?

We can’t know for sure if rising prices will become the new ‘new normal’, or if they’re just a temporary result of us emerging from a pandemic and a year of lockdowns and restrictions.

A rise of the base rate to 1% would see interest rates back at 2009 levels, a time when the economy was in recovery following the financial crisis.

But this would still be a far cry from 1979 when interest rates were hiked to 17% by the incoming Conservative government to curb runaway inflation. Or the 12% rate brought in after the UK withdrew from the European Exchange Rate Mechanism in September 1992.

However, the economic recovery does look particularly weak right now. UK Gross Domestic Product (GDP) growth came in at 0.4% in August, even before the gas price spike, there’s been a fresh surge in job vacancies to 1.1 million, and a fuel supply crisis. This might well have slowed growth even further in September.

Central banks certainly don’t want stagflation taking hold, where stagnating growth combines with rising prices. So, it’s likely any rise in rates will be measured and incremental.

Unwinding the mass bond buying programme which has helped make borrowing cheap is also likely to be a slow process. The last shock governments want right now is to see the interest payments they have to make on the national debt rise.

Central bank policymakers will also be keen to avoid any kind of ‘taper tantrum’ in the bond markets. This is what we saw in 2013 when US treasury yields rose sharply after the Federal Reserve announced a roll back of its quantitative easing programme.

So what should investors do?

Central banks want to tempt a Goldilocks economy back. Not too hot, not too cold, but just right will be their aim as they try and keep a lid on bubbling prices and bring economic growth back.

Investors would be wise not to become too bearish themselves and adopt a wait and see approach. As ever, it’s important to hold a well diversified portfolio for the long term, rather than trade on any mild movement in central bank policy.

Saying that when inflation strikes, cash gets less valuable. So it’s important to make sure you get the best interest rates you can on your cash savings.

How Active Savings can help

Historically, stocks have managed to outpace inflation over the long term, though high inflation probably wouldn’t be helpful. However, not all companies are equally well positioned to withstand a prolonged period of price pressure and past performance is not a guide to the future.

Companies with strong pricing power have tended to be able to pass on rising costs to their customers. In times like this, companies that already generated strong profit margins have tended to hold up better. By the same token, companies with thin profit margins could start to struggle if prices continue to rise. Though as always there are no guarantees.

This article isn't personal advice. If you're not sure if a particular investment is right for you, seek advice. Unlike the security offered by cash, all investments and any income they produce can fall as well as rise in value so you could get back less than you invest.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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