For those who can remember them, it might appear that the 1970s are back. We’re not at the stage of a three-day week, power cuts, petrol shortages and TV stations closing down after 10pm, but there are clear economic parallels between now and then.

And one of the words bandied about back then – a word economists and politicians said no longer existed in this era of ‘entrenched stability’ (Gordon Brown, 2005) – is definitely on the comeback: inflation.

Just as doctors in the UK are starting to see evidence of resurgences in illnesses that we thought were consigned to history – TB, whooping cough, measles – economists have known for some time that the dreaded spectre of inflation is back to haunt us.

Perception versus reality
The official annual rate of inflation, compiled by the Office of National Statistics, published by the Bank of England and endorsed by the government, was 2.5 per cent in February 2008, up from 2.2 per cent in January 2008.

However, a report entitled The Cost of Living Under Labour (which was commissioned by the Conservatives) found that average household gas bills have risen by 108.6 per cent since January 2003, while electricity bills have increased by 69.6 per cent over the same period. Since Gordon Brown became prime minister, the price of eggs has risen by 34 per cent and the cost of butter has increased by 37 per cent.

But the government still insists that inflation is running at 2.5 per cent a year, despite the escalating expense of council tax bills, the rising price of the weekly supermarket shop, the soaring cost of filling up the car’s petrol tank and the utility bills that just seem to grow out of all proportion to your dwindling consumption of them. So why, if we’re told inflation is benign, do we all feel poorer?

‘It is because of how the government measures inflation,’ says Gavin Oldham, chief executive of The Share Centre. ‘It uses the harmonised Consumer Prices Index, or CPI, which is an absolute whitewash. We used to measure inflation using the Retail Price Index (RPI), which is a much more accurate measure.’

He points out, ‘Everyone knows RPI drives the world and is even used on MPs’ pensions as an escalator, but CPI misses out half the things that matter, such as petrol, council tax, utilities and housing costs, which is why the government tells us inflation
is so low but why we all know everything that matters is getting more expensive.’

The grand illusion
The change to the CPI from the RPI is a fairly recent one – Gordon Brown announced it in his pre-Budget speech of 10 December 2003 – and it was made, ostensibly, to bring the UK’s measure of inflation in line with the one used by the European Central Bank.

But Gordon Brown, mindful that the last Labour chancellor, Denis Healey, presided over an economy in which inflation hit 26 per cent a year in 1975, also knew the switch would work in his favour. As the CPI rises at a slower rate than RPI, he could claim the economy was running better than it actually was (see chart on page 16).

When he announced the switch, RPI was running at 2.8 per cent a year, while CPI was running at 1.3 per cent. In February 2008 (the latest available figures at the time of writing), the CPI was 2.5 per cent but the RPI was running at 4.1 per cent. Chris Hills, chief investment officer at private client investment manager Rensburg Sheppards, points out that ‘According to the economist Roger Bootle, the switch from the RPI to the CPI reduces the inflation figures by about 0.4 per cent per annum. So as time goes on, the gap between the two will get wider and wider.’

Even Sir Stuart Rose, chairman of Marks & Spencer, says that the real inflation rate is around eight per cent, while pay rises are closer to three per cent. But why all the fuss? Why does inflation matter anyway?

‘The simple definition is that inflation reduces your purchasing power – either the purchasing power of income in the short term or the value of your capital in the long term,’ says Hills. ‘I don’t think there is any evidence that we’re heading back to the awful times in the mid to late 1970s, but if anyone is under any illusions of how unchecked inflation can ravage an economy, they need only look at the current economic situation in Zimbabwe.’

Reduced purchasing power
It is an extreme example, but Hills has a point. For the true horror of inflation, you need only consider the economic plight of Zimbabwe under Robert Mugabe’s 28-year stewardship. Zimbabwe’s Reserve Bank stoked hyperinflation by printing more money, until inflation hit 100,000 per cent a year. To put that in perspective, in 2000, 14 million Zimbabwean dollars would have bought you a mansion in the country’s capital, Harare. In March 2008, it was enough to buy one can of soft drink.

That is the ‘front end’ of inflation – inflation that is rising on the back of rising prices and eroding the purchasing power of your money, so that a ‘basket’ of goods costs more even though your income remains fixed. The net result of this process is that you spend more of your money to maintain your standard of living. The ‘back end’ of inflation is making sure your investments grow faster than inflation, so your capital’s purchasing power doesn’t get obliterated by rising prices.

But realistically we are not back to the bad old days of the 1970s, nor are we likely to suffer hyperinflation on a Zimbabwean scale. Nevertheless, The Share Centre’s Gavin Oldham thinks a bit of inflation might do us some good. ‘Unlike in the 1970s, we now know how to control inflation,’ he says. ‘But I don’t think we know how to control it at such low levels. In the USA, the Federal Reserve is aggressive at cutting interest rates, but in the UK we dither. So, because the Bank of England is slow to cut rates, I think the pain of rising inflation will be with us here in the UK for longer than perhaps it needs to be.’

Coping with the pressures
So how do you protect your investments from rising inflation? Gavin Oldham’s advice is to ‘avoid cash – it has a built-in loss-making element, which is the price you pay for knowing your deposit is 100 per cent safe’.

Ben Yearsley, investment research manager at IFA and broker Hargreaves Lansdown, suggests that investors look at ‘boring National Savings index-linked bonds’, pointing out that beating inflation is what they were designed to do. ‘If your primary concern is beating inflation, and you want something that outperforms cash but is as safe, they’re hard to beat,’ says Yearsley.

Currently, you can invest up to £15,000 in each issue of certificate and have to hold it for between three and five years. The extra kicker in your return is that it is free of UK income tax and capital gains tax. If you prefer the flexibility of an investment fund, Yearsley says that Axa Distribution, managed by Jim Stride, has around 50 per cent of its portfolio in index-linked gilts. ‘If you are looking for equity income, then Invesco Perpetual Income, managed by Neil Woodford, is a top choice,’ says Yearsley. ‘Even though the markets look shaky, rising inflation means rising prices, which means rising profits, which, in turn, means rising dividends.’

Rensburg Sheppards’ Chris Hills says that, as stock markets look choppy, capital values can be volatile, but that shouldn’t put you off equity income. ‘The big test of funds maintaining their income came in 2002, when the FTSE All Share almost halved in value over two years,’ he says. ‘But company dividends didn’t fall in line with share prices, and dividends, although never guaranteed, have a certain amount of built-in inflation proofing. Since the Second World War, inflation has averaged five per cent per year, but dividend growth has averaged seven per cent per year.’

The case for diversification
But what about commodities and, in particular, gold, the classic hedge against inflation? Ben Yearsley feels that investors who want exposure to gold should invest in Merrill Lynch Gold & General – but he cautions that this should form only five per cent of their portfolio and that they should be mindful of gold’s volatility. ‘It is not for widows
and orphans,’ he says.

According to ETF Securities’ end-of-first-quarter results for 2008, commodities were once again the top-performing asset class, up 9.4 per cent, outperforming equities by 20 per cent. But Chris Hills sounds a note of caution: ‘When the gold price spiked up recently, the demand for the gold ETF equated to 20 per cent of the entire annual production of South Africa. As the supply of gold is constant but the demand is rising, this completely distorts the supply and demand equation. At some point, emerging economies might have a fall in demand, and if the supply catches up it’ll mean prices will fall. Yes, gold is the classic inflation hedge, but it is volatile and investors should never forget that.’

Gavin Oldham believes equities deal with inflation quite well – they reflect the wider economy because businesses will always maintain their profitability. ‘I would steer clear of domestic consumer companies because, as consumers tighten their belts to pay for rising food, fuel and taxes, if they can’t get credit they’ll cut down on spending,’ he says.

He adds, ‘Instead, I would look at companies in sectors involved with exporting – aerospace, defence, household goods and engineering. At this stage of the cycle, with the pound falling against the euro, the exchange rate is in their favour: this is their turn.’
And Oldham concludes, ‘Where inflation is concerned, economically, I think we’ll have a moderately awful time of it over the next few years. But the markets will be OK, simply because business is run far more efficiently than government.’