Will inflation leave us feeling deflated?

Posted on: 15 December 2010 by Rhian Mainwaring

Peter McGahan discusses how inflation and deflation can benefit the current financial climate...

Inlfation Peter McgahanIt used to be easy to understand the markets. You could read sentiment and marry that with reasonable economic data but today it’s a great big bun fight that makes it suitably complicated for some.

Why do we have inflation when most countries are fighting their way out of a depressive state, when the world's biggest economy is still knackered, and when the average consumer doesn’t know the impact or detail of the next big cut?

It's all a bit complicated so I will try and make some sense of the noise that I am bombarded with every day.

Who would inflation suit?

Inflation will suit anyone with a large debt/deficit. That will be the UK and the US I suppose. Inflation effectively erodes the value of the debt. For example, inflation at 100% effectively means the debt is worthless. And so controlled inflation would be good.

But if inflation is a threat wouldn’t you need to increase interest rates, which would kill off the UK and the US as they are in so much personal debt? I believe it would and so it's surprising that the Bank of England and Fed are not that bothered, it seems, about inflation at the problematic levels they are.

However, they still keep talking about inflation and the potential for deflation when everything is more expensive than it was before. I can see that we should have deflation, after all, we are all worried about cuts and we are all paying down the debt we have rather than spending, so yes we should have deflation. 

Deflation would be bad for business/equities and more importantly bad for the UK who would effectively have a debt that’s increasing. And so, quantitative easing (wrongly referred to as printing money) is introduced.

It's supposed to be effective in reducing the cost of borrowing money but there is little evidence of that. It has however, been effective in driving down the image and value of Sterling, which amazingly has two benefits for the UK:

  • Holidays abroad are more expensive for us, so we stay here, and holidays here are cheaper for tourists who come and spend;
  • Exports are cheaper and imports are more expensive so it balances out the numbers, but also, because imports are more expensive, it creates a bit of inflation, which helps reduce the debt via inflationary means. Exports and tourism are acceptable to any economy as its all new money. Life's good. Bored? You shouldn’t be!

Where is inflation coming from?

Apparently, it's raw goods, metal, oil etc. Hmmmm, how does that work then? Everyone's worried about Armageddon yet raw goods are rocketing in price? That’s a puzzler. So, how can raw goods be worth more when demand is less?  

I refer you back to this column in 2008 when I called the 'deflation' bomb and contradicted Goldman Sachs' view on where oil would be going. In the column I showed that the total amount of capital invested into index traded strategies into commodities equalled $13bn in 2003. This is the maximum it had ever been. If in 2008, it had been $16bn it would have been a marked spike. Instead, the number was a staggering $260bn. All demand for the actual commodities was neutral or negative so prices should have been falling.

Apparently the laws had been relaxed which allowed for investors to buy commodities on margin i.e. instead of paying $100 for $100 oil or wheat, you could put down just 8% of the trade ie $8. Therefore you could achieve a twelve times exposure to a market if you wanted.

Investors were also allowed to gain exposure to commodities by investing via what's called an over the counter swap, ie you effectively can hide positions you are taking in commodities. So with all the talk about bashing the banks/governments that were doing it: What has actual action been? Simply put, none!

And so, the aforementioned can create their own inflation, we pay more for our goods and the economy is rebalanced at our expense through inflation. Marvellous, eh?

Michael Masters

Peter McGahanPeter McGahan is an Independent Financial Adviser and Managing Director of Worldwide Financial Planning. Worldwide has won 16 Financial Times awards in the last four years. Peter has also been named the top media IFA of the year by Unbiased.co.uk in 2009.

Peter comments regularly in major journals such as the Mail on Sunday, Irish News and Sunday Times and is a weekly columnist for FT Adviser. He has also appeared on Working Lunch and the Today programme. In addition he is an expert on international tax matters for a range of international publications.
Worldwide Financial Planning Ltd are authorised and regulated by the Financial Services Authority. 'The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.'

Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made. The above represents the personal opinions of Peter McGahan. All information is based on understanding of current tax practices, which are subject to change. The value of shares and investments can go down as well as up.

If you have a financial query you would like Worldwide Financial Planning to respond to, call 0845 230 9876 or email info@wwfp.net.

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