Last week the Bank of England admitted in its latest inflation report that prices had been rising faster than expected.
It forecast that inflation on the CPI measure would rise above its 2% target over the next three years, due largely to an increase in the price of imports. Interest rates may therefore go up further to cool spending and dampen inflation.
Alan Greenspan, chairman of America’s Federal Reserve, is expected to raise US rates from the present 2.5% to 3% this year to keep a lid on inflation.
However, there are risks to the Bank of England’s forecast. If the housing-market slowdown hits consumer spending, inflation may turn out lower than expected. If, on the other hand, wages accelerate, they could push up prices.
Simon Rubinsohn, an economist at Gerrard, a stockbroker, said: “We think there is evidence of a modest acceleration in pay settlements. Given this, we still think there will be one more rise in the base rate to 5% as the Bank tries to keep inflation on target.”
Advertisement
But even if inflation remains subdued, it can erode the purchasing power of your savings at startling speed. If you have a lump sum of £10,000 and prices are rising 2.5% a year, your cash will be worth only £6,000 after 20 years if you earn no interest.
Paul Ilott of Bates Investment Services, an adviser, said: “All savers should aim for a positive return after inflation and tax. Fail to do that and you might as well spend your money now because it will buy less in future.”
Higher-rate taxpayers need to earn at least 3.5% from their savings accounts to beat tax and inflation, according to Ilott; basic-rate payers need 2.63%.
However, four out of ten accounts fail to make the grade for higher-rate taxpayers. One in five does not pay a positive return to basic-rate taxpayers.
Ilott said: “Savers tend to think that deposit accounts are risk-free, but that isn’t the case when you take tax and inflation into account, especially for higher-rate taxpayers.”
Advertisement
Egg, the internet bank, is offering the best savings account with a rate of 5.5% on balances of more than £1. The rate includes a bonus of 0.75 percentage points for six months and is guaranteed at least to match the base rate until December 2007.
AA has a telephone account that pays 5.31% on balances of at least £500, including a bonus of 0.6 points for 12 months.
Savers can earn even higher rates on regular savings accounts, but there are usually restrictions. HSBC will tomorrow launch an account paying a fixed 8% for 12 months if you credit the account with between £25 and £250 a month by standing order. You must open an HSBC current account and cannot make withdrawals, but you can miss some payments.
National Savings & Investments (NS&I), the government’s savings agency, offers schemes guaranteed to keep pace with inflation.
Its five-year index-linked savings certificate offers a return equal to the rate of inflation plus 1.05 points. With the RPI at 3.2%, it is paying 4.25% and returns are tax-free. A higher-rate taxpayer would need to earn a gross 7.08% from a standard deposit account to beat that; a basic-rate taxpayer would need 5.31%.
Advertisement
Savers who have ventured out of cash into bonds and equities face a different range of threats from inflation.
Many investors have piled into bond funds over the past few years as an alternative to volatile equities. But rising inflation is usually bad for government bonds (gilts) and high-quality corporate bonds because they pay fixed interest rates.
When inflation and interest rates are expected to go up, the fixed income becomes less attractive and prices fall.
However, this relationship has broken down recently. Bond prices are higher and yields lower than a year ago, even though the Bank of England has been raising rates to limit inflation. The yield on 10-year gilts is 4.58%, compared with 4.76% a year ago.
Jim Leaviss, head of fixed income at M&G, a fund manager, said: “Bonds have been supported by pension funds, which are switching out of equities and into bonds to plug their deficits.
Advertisement
“I think the outlook remains good. The Bank may expect inflation to rise above the 2% target, but it has emphasised the danger that consumer spending will weaken and keep inflation in check. We agree and think bond prices will continue to perform well.”
When inflation is rising, advisers often recommend index-linked gilts. Unlike conventional bonds, the income rises or falls in line with prices.
Say an index-linked gilt has an interest rate (or coupon) of 2% for 20 years. Investors would get £2 a year for every £100, adjusted for inflation. If prices rose by 2.5% in the first year, savers would receive an income of £2.05 (£2 plus 2.5% of £2). If inflation continued to rise by 2.5% a year, the income would increase gradually to £3.28 in the final year.
At the end of the term, your capital is adjusted for inflation. If prices rose by 2.5% a year for 20 years, your £100 would be worth £163.86 at maturity.
However, you pay a price for this protection. The coupon on an index-linked bond maturing in 2009 is 2.5%; the rate of interest on a conventional gilt maturing at the same time is 4%.
Advertisement
To work out if an index-linked gilt is a good buy, look at the difference between its yield and that on a conventional bond. This is called the break-even rate and shows the market’s view of inflation. The difference is now 2.9%.
Leaviss said: “If you think inflation could average more than the break-even rate over the term, index-linked gilts could be a good buy. However, we think inflation will be lower and index-linked gilts therefore look expensive.”
Equities are also considered a good hedge against inflation. If prices for goods and services are going up, you would expect company earnings to rise, which should boost share prices.
However, you must hold shares for at least 20 years to get protection from inflation, according to the authoritative Barclays Equity Gilt Study.
It said: “In the short run, equities are not necessarily the best hedge against inflation. Investors with a holding period of one to five years could still be burnt. To get consistently positive real returns, you must hold equities for at least 20 years.”
Property and commodities are a better hedge against inflation, according to the Barclays study. You must hold property for 15 years to get positive real returns, while the holding period for commodities is only 10 years. Barclays said: “Commodities are the best asset to protect against any unexpected spikes in inflation.”
The cost of raw materials such as oil has soared in the last two years, and this has pushed up the price of goods and services. Ilott said: “I believe there is a case for investors to have a small proportion of their portfolio in commodity funds — perhaps 5% to 10%.” He tips the Merrill Lynch Gold and General fund and the JPMF Natural Resources fund.