Inflation Higher Than In 1991

The UK of the early 90’s was one of high unemployment, record interest rates, house price collapse, recession and coincidentally, a Tory leadership challenge followed by a change of Prime Minister.

Until recently, that was but a distant memory as inflation was one of those regularly published economic measures which went largely ignored. It was always present – give or take a brief dip into negative territory in 2015 – but after the last blip above 5% in 2011, it has not been a concern.

Until now.

As the graph below dramatically illustrates, inflation has surged since the start of 2021, when the Consumer Price Index [CPI] measure of annual inflation was just 0.7%. The latest figure (for April 2022) shows the CPI rising by 2.5% - in one month, not a year. The annual CPI rate was 9.0%.

CPI Inflation since January 1989

Source: Office for National Statistics

For once there are no historical comparisons, as the Office for National Statistics (ONS) data only goes back to January 1989 and shows a 1991 peak of 8.4%.

The UK is not alone in experiencing a sudden bout of inflation. In the USA inflation was running at 8.3% in April, while in the Eurozone, which had been trying to avoid deflation not so long ago, the monthly reading was 7.4%.

Update 23/06/2022 - The figures for May have been confirmed as 9.1%, up from the 9.0% in April. It is being reported this is the highest since March 1982 which is of course an estimate using older measures since the CPI records only go back to 1989.

Upward drivers last month were Food & non-Alcoholic Beverages, Transport and Household Goods (things we need and buy regularly) and downward drivers were Recreation & Culture and Clothing & Footwear (things we can do without buying new).

I wouldn't be surprised if the reported figure next month is lower, however the cost of living will still feel more.

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The consequences

There are many effects from an inflation rate more than three times the 2% target which the Treasury sets the Bank of England. Three of the more significant are interest rates, taxation and your personal finances.

Interest rates

In recent times the way in which inflation has been tackled has been to raise interest rates. The Bank of England’s Monetary Policy Committee has already done so at each of its last four meetings, leaving its base rate still at just 1%. Further rate rises are expected, but the Bank is in a bind which it shares with the central banks in the USA and Eurozone:

• Rates are increasing from a near-zero level, where they have been since March 2009;

• It is far from certain how high rates will have to rise to bring down inflation, especially as some of the main causes, such as rising energy prices, are globally driven; and

• With the backdrop of the war in Ukraine and a slowdown in China prompted by COVID-19 lockdowns, raising rates runs the risk of driving the economy into a recession.

Bank of England base rate increases do not immediately feed through to mortgage costs in the way that they used to, because these days about three quarters of mortgages are fixed rate. However, as the fixed terms end – and many were only fixed for two years – the impact of higher rates will be felt. When rates have been so low for so long, an extra 1% on the rate can translate into a large percentage increase in mortgage payments.

Taxation

In his March 2021 Budget, the Chancellor announced that he would be freezing the income tax personal allowance, the higher rate threshold, the inheritance tax nil rate bands and the capital gains tax annual exempt amount for four years, starting in 2022/23. At the time, the Office for Budget Responsibility (OBR) was projecting the inflation between 2022 and 2025 would average 1.9%. That made the freezes seem a tolerable way of raising extra revenue.

A year later, the Chancellor had not changed his mind on the freezes, but the OBR had altered its thinking on inflation. In March 2022, it expected inflation over the four years to average 3.7%, a figure which is already starting to look like an underestimate. The OBR highlighted the result of the higher inflation assumption in its March 2022 Spring Statement, estimating that:

• The number of people brought into income tax by 2025/26, the final year of the freeze, had risen from 1.34 million, in its March 2021 report, to 2.77 million a year later; and

• The increase in higher rate taxpayer numbers had doubled from its previous projection to 2.0 million, meaning that in 2025/26 nearly one in five income tax payers would suffer higher rate tax. If you are not a higher rate taxpayer today, you may be by 2025.

Personal financial planning

High inflation can rapidly disrupt your financial plans. For example:

• If your life assurance, critical illness cover and income protection are not index-linked, the value of cover you have will be eroded. £1 at the start of 2020 had a buying power of 92.4p by March 2022.

• Investment returns need to be thought of in ‘real’ terms. That means subtracting the inflation rate from the simple return to see whether your capital is keeping pace with inflation. A 5% return will still see the worth of your capital fall by 4% a year if inflation is 9%.

• Pension contributions need to keep up with inflation. If you maintain them at a fixed level, then you are allowing inflation to make your retirement poorer. A corollary is that if you are, or are about to, draw benefits from your pension, you need to build in some provision for inflation protection of your income.

• Cash holdings are generally bad news because interest rates are so far below inflation – back to the issue of real investment returns. Large cash deposits are even harder to justify when their buying power is dropping by 5% or more in a year.

Action

Inflation is a major disruptor and one that is all the worse for its sudden appearance. It will probably mean that you lose more of your income to tax, thanks to the Chancellor’s freezes.

It may also mean that you need to review your finances and set new priorities.

Our cashflow planning tool can plot scenarios with differing inflation rates to help you see how it could affect your long term plans. Let us know if you want yours updated.