The first major news for financial planning this year (Happy New Year, by the way) is that inflation has fallen back to 2.5%, more or less exactly where it is supposed to be. This is excellent news for thos looking to build up a robust financial plan, as the recent highs of some 12 or 13% for inflation would reduce the spending power of any portfolio to a tiny fraction of its starting position in no time at all. But what does it means when inflation falls for 2.5%?
What is Inflation?
Getting this out of the way immediately, it has nothing to do with balloons. Instead inflation is a term for the devaluation of money. As a practical example, think back to how much a Mars Bar cost when you were a child and then look at the price now. Likely you will see it go from around the 25p level if you are around my age to the current 80p or so. This indicates a total Mars Bar inflation of around 220% since I was a child. Over 30 years or so, that equates to an average Mars Bar inflation rate of about 3.3% a year, a little higher than the current official rate of inflation, but applying to something I have direct experience with.
This demonstrates a very key point about inflation – it will vary depending on what basket of goods you use as a reference measure for price. This means the government tracks a very wide array of inflation figures, but the one most often quoted is the Consumer Price Index, or CPI. This is a measure which includes representative goods for everyday purchase. This includes food and drink, clothing, alcohol and tobacco, transportation, recreation and culture, and restaurants, among other things. Importantly it does not include rising house costs – this was indirectly included in the Retail Price Index, a measure used by the government before switching almost entirely to the Consumer Price Index.
The result of this is a basket of goods that should apply to an average household where the mortgage has been paid off. In many cases, you will likely be reading that and saying “but I have a mortgage, and it’s a huge part of my expenditure”, and that is exactly why this is not a perfect measure for how much more expensive things are getting.
Inflation Falls to 2.5% – is it Good News?
Yes, with a caveat. Hearing the news that inflation falls to 2.5% was very good for forward planning. But it does nothing to affect how much more expensive things alread are than a few years ago. Looking at the cumulative Consumer Price Index over the last five years, the data still shows some cumulative inflation of 25%, which is a very high rate for such a short timescale. This reduction to 2.5% doesn’t undo that damage, it just makes future damage less impactful. Things are still hugely more expensive than they were, this news simply demonstrates that things are not going to get worse anywhere near as fast as they were.
Conclusion
It probably sounds like I have been very negative with this, but I want to stress that this is still good news despite all the warnings I have given. Various academic studies over the years have shown that a little bit of inflation is good for an economy because it disincentivises the hoarding of cash.
With a well balanced portfolio, it is certainly possible to outperform inflation over the long run, with the higher returns doing so by a comfortable margin (last time I checked, the Barlays Equity Gilt study showed that UK equities over the very long term would provide annual average return of over 5% above inflation).
What this new should do is remind you that holding large quantities of cash for the long term is a bad idea, because in 30 years that 80p Mars Bar might well cost you £8.26 if the same inflation rate applies.
