Inflation – what are the most important takeaways?

Inflation – what are the most important takeaways?

by | Jan 19, 2022

You have no doubt all heard about the inflationary winds currently blowing through global economies, with rising energy prices arguably the most visible effect. The US is worst hit, with annual inflation to September running at around 5.4%. In the Euro area, the corresponding figure is 3.4%. France is relatively sheltered, for now at least, with annual prices to September rising at 2.2%.

Of course inflation hits some people more than others. If you are still working, for example, your wages may rise in line with inflation, arguably making it net neutral.

We cannot explore every profile within this article, but one thing we can say with fairly high certainty, is that if you have money sitting in a savings account, over 2021 those funds are very likely to have lost purchasing power.

In economic circles the great debate is around whether this inflation will be transitory, or not. There are certainly inflationary pressures today, caused by disruptions to global supply chains post COVID, as well as other local factors. On the other side of the coin, there is an argument that inflationary pressures will be counter-balanced over time by technological advances (automation for example) which are deflationary in nature. This has certainly been the underlying trend over the last decades and these are powerful forces. The point is, nobody knows. Economists can argue the point until the cows come home and quite frankly I cannot help thinking this is clouding a more important question: What is likely to be the relationship between inflation & interest rates? For this is what will concern us most.

It is widely agreed that Covid related supply chain issues (think semiconductor chips, or transportation bottlenecks) are likely to last at least another six months, so even those convinced of the transitory inflation scenario are likely to acknowledge there will be inflationary pressures in the months to come. How will this affect us?

Let’s go back to those with a savings account (probably most of us). At best, interest on a savings account in France is now not much more than 0.50% per annum, so not even a quarter of the annual inflation rate as noted above. At these rates our money is actually losing more than one and a half percent of real purchasing power.

Hence my earlier question, what is likely to be the relationship between inflation & interest rates? We have already talked about inflation, but what about interest rates?

Interest rates are predicted to rise in the years to come, although very slowly. In Europe, for example, the European Central Bank will not want to repeat their mistake of 2011, when they raised rates in April and July, only to cut them again in November and December!

In fact the cynical view would be that interest rates are likely to rise very, very slowly indeed! The argument being that central banks (technically apolitical) will nevertheless be under enormous political pressure not to raise rates (too far). This is because governments around the world have taken on enormous amounts of debt, which is going to be very difficult to pay off without either raising taxes or cutting spending, neither of which are going to win popularity contests (aka elections). Furthermore, it will be extremely expensive for governments just to service the interest payments, if interest rates go up.

Thus for indebted governments, and indeed anybody owing money (a mortgage, for example) a little real inflation (inflation minus the rate of interest) can actually be somewhat beneficial, as it would effectively inflate away some of the debt.

So what can we takeaway from all this? Well, if we believe there is likely to be some inflation in the economy, be it in transitory bouts or in a more prolonged fashion, and if we believe interest rates are likely to remain below the rate of inflation for a notable period of time, then we have to consider whether we can afford to leave all our savings in low interest accounts, where they are likely to be eroded, in real terms, over time.

In the meantime, we can just be thankful we are not living in the US!

This article was first published in the Connexion in January 2022