It’s been difficult to catch up on the news lately without seeing headlines of inflation hitting 30-year highs. But are we heading back to the 1990s? What can be done? And does inflation even matter in financial planning, asks Steph Willcox, Head of Actuarial Implementation at Dynamic Planner?
What is inflation?
Inflation is the decline of purchasing power of a given currency over time. As is tradition when discussing inflation, this can be demonstrated by the price of Freddos. When I was small, I could buy 10 Freddos for £1. Now I can only buy four. Therefore, my purchasing power has been eroded by Freddoflation.
An estimate of inflation can be reflected in the increase of an average price of a basket of selected goods and services in an economy over a period of time.
The rise in the general level of prices, often expressed as a percentage, is the thing that we state as inflation.
It is of course important to remember that the price of goods can be affected by lots of things, all of which will be captured as ‘inflation’, but could be driven by currency fluctuations, supply issues, increases in business expenditure or any number of different reasons.
Equally, it’s important to recognise that different goods increase in price at different rates, and ‘inflation’, as it is calculated, is only an estimate of the average change in purchasing power.
Freddos have traditionally increased much quicker than inflation, so if your entire basket of goods was made up of Freddos, (please note, this is not a recommendation), your personally experienced inflation level would be much higher than the average inflation level quoted.
What is high inflation?
The Bank of England’s Monetary Policy Committee is responsible for maintaining a target inflation rate, currently set at 2%, although their expectations are that inflation will remain around 5% until April 2022 when it will peak at 6% before gradually returning to the targeted rate.
This level of high inflation is being influenced by emerging from the pandemic, rising consumer energy prices, disruption to supply chains and good shortages.
Of course, the inflation level can’t be allowed to drift forever and the MPC will take measures to reduce inflation through a change in monetary policy. It’s important to note that monetary policy cannot solve supply-side issues, but it can still be used to alter inflation levels in the medium term.
The Committee can choose to change policy in the form of an increase to interest rates, or a reduction in the current quantitative easing programme.
As interest rates rise, borrowing through loans and mortgages becomes more expensive and savings become more profitable. This shifts consumer habits away from spending, reducing demand, and therefore reducing inflation. We’ve already seen one increase in interest rates, making England the first developed nation to increase interest rates following the global pandemic, and more rate rises are expected.
Quantitative easing, which was first introduced in 2009, is where the Bank of England buys back bonds from the private sector, financed by the creation of central bank reserves.
The aim is to increase the price of bonds, by stimulating demand, which will reduce bond yields. As bond yields reduce, so does the interest rates on savings and loans. Therefore, stopping quantitative easing would be expected to reduce the demand of bonds, reducing the price, and increasing the yields. Increasing bond yields will increase interest rates on savings and loans, and thereby lower inflation.
Changes in monetary policies can take up to two years to see their effects fully felt within the economy, so any change in policy will not be a quick fix.
Should I be worried about inflation in financial planning?
With inflation playing such a major role in an individual’s purchasing power, it’s of course vitally important that this is reflected in the advice process, and it is even more necessary when creating a long-term cash flow plan for your clients.
As we see, inflation is not a static number and therefore shouldn’t be modelled as such.
Dynamic Planner forecasts real returns – therefore net of inflation – across its system, in the risk-reward trade-off shown for risk profiling, in investment portfolio reviews and in cash flow planning.
The forecast is generated by a Monte Carlo scenario engine that generates thousands of possible real returns over 49 asset classes. As the returns are real to begin with, the various possibilities for inflation at different times are already factored in. It is therefore inappropriate to guess and factor in other numbers for inflation and apply them to the forecast.
As both the returns and the forecasts are real, you don’t need to worry about inflation – it’s already all accounted for. You can be confident that you are seeing the expected purchasing power of a client’s assets at each point in time, even through these times of increased volatility.
Further to this, the Asset Risk Model and the Dynamic Planner risk profile asset allocations are stress tested to ensure that you can have confidence in our growth assumptions and plan confidently with your client. The stress testing performed in late 2020 focussed purely on inflation and the emergence from the global pandemic.
So, perhaps now is the time to reassure your clients that inflation fluctuations are expected and covered in our modelling, and that their retirement plans will remain on track – as long as they’re planning on purchasing something that isn’t a Freddo.
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