Enjoy low inflation while it lasts

August 18, 2009

david Kuo- David Kuo is director at the Motley Fool. The opinions expressed are his own.-

If you are not confused you are not paying attention. Those sage words from management guru Tom Peters can be applied to a wide number of economic issues today, but none more so that to the latest inflation figures.

Question is: do we have inflation, deflation or some mixture of the two?

The answer lies in which index you are looking at?

Inflation as measure by the Consumer Prices Index (CPI) has held firm at 1.8 percent. But according to the Retail Prices Index (RPI), which excludes mortgage costs, inflation for July came in at minus 1.4 percent – that’s up from minus 1.6 percent in June.

So if you are a homeowner with a mortgage, then your cost of living is 1.4 percent lower in July than a year ago. But if you don’t have a mortgage, then the basket of goods that you regularly buy is 1.8 percent higher than a year ago.

The stickiness of the Consumer Prices Index, whilst the UK is in the midst of the worst recession for decades, poses an interesting problem for the Bank of England. In theory inflation should be lower as demand for goods and services are restrained by a fear of unemployment. Retailers, for instance, have been cutting prices to drive growth. Yet core inflation refuses to drop.

This raises the question as to how quickly inflation may rise when the UK economy eventually emerges from recession. For instance, how soon will the rise in the price of oil this year start to seriously drive up the cost of goods?

Additionally, with signs of a nascent recovery in Asian economies, how quickly will increase in demand start to affect prices in the UK? It is naive to ignore the purchasing power of the Asian consumer, which can have a direct impact on the cost of raw materials, minerals and food on the West.

Another area of concern lies in the extent to which quantitative easing by the Bank of England is storing up price pressure in the future. The Bank of England has increased the amount of money it will pump into the UK economy by 50 billion pounds to 175 billion pounds. But the big question is whether the Bank of England can mop up the money quickly when the economy starts to grow.

It is easy to consider inflation as an irrelevance now. But it would be wrong not to guard against inflation in the future. For starters, VAT will be restored from 15 percent to 17.5 percent in January. This will immediately push up consumer prices. As a consequence, the Bank of England will be forced to take action by hiking rates.

So, enjoy low inflation while it lasts. If you have debts, try to pay them down quickly while interest rates are low. If you are debt free, then consider investing in inflation-beating assets. Historically, only two asset classes have successfully beaten inflation. These are property and shares. So, if you already own a house, then start investing in the stock market now.

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