In one way or another, we are all consumers and it won’t have escaped the notice of most readers of What Investment that there are frequent discrepancies between the official measures of inflation and the actual rates at which prices rise for specific groups of investors - particularly those in retirement.

As economies across the globe begin to buckle under the sustained pressure of the downturn, and stock markets do their best to stage a recovery, a growing number of economic commentators are concerned about the risk of deflation.

In response, the latest attempt to shore up the global financial system, saw the UK, and other major economies, implement ‘quantitative easing’, a process designed to increase the level of economic activity, specifically lending. This follows numerous failed attempts to stimulate economic activity by cutting base rates.

Assessing the risks
Will it work? Maia Capital’s Jason Collins believes, ‘In the current environment, the big
risk is that the authorities run out of tools to tackle the problem and we fall into a Japan-style “lost decade” – hence the desperate measures governments are undertaking now to prevent this occurring.’

However, actions such as these do not come without consequences and investors
are now faced with a crucial dilemma – whether to position their portfolios
to hedge against inflation or deflation.

Collins explains, ‘Inflation is just like Goldilocks’ porridge in the tale of the three bears. There is an ideal level, where the economy is not too hot and not too cold. This is why the Bank of England (BoE) does not have a zero inflation target; while high inflation is painful, if it falls too low then the economy will contract and fall into recession.

‘The credit crunch means that the Goldilocks scenario is now just a long-forgotten fairytale. Some investors are focusing on the threat of deflation, driving gilt yields to record lows, while the recent implementation of quantitative easing, effectively printing money, has led others to start worrying more about inflation taking
off again.’

Up today, down tomorrow
Inflation, as measured by the Consumer Price Index (CPI), the official figure, surprisingly increased in February to 3.2 per cent, significantly ahead of both City expectations and the Bank of England’s two per cent target.

But the Retail Price Index (RPI), which includes mortgage interest payments, plummeted to zero per cent.

Using the RPI measure, there is now increasing speculation that we are entering a period of deflation – defined as a period of falling prices. The last time this happened was in the first quarter of 1960.

‘On the one hand, deflation can boost confidence and spending power as money can go further,’ suggests Meera Patel, senior analyst at Hargreaves Lansdown. ‘As prices fall over time, money becomes worth more and it eases the burden of any rising prices. However, if it persists for a prolonged period of time, it is not good for the economy.’

She adds, ‘Deflation can deter individuals from spending today as they expect prices to fall tomorrow. Businesses will also delay investing if they believe it will be cheaper in the future.

‘If deflation feeds into wages, leaving workers taking less money home, this would increase the real value of debt. Deflation is therefore bad news for borrowers and this could be a further hindrance on any improvement of the economy.’

Pension silver lining
However, while this may be bad news for those with high levels of debt, pensioners could benefit from a period of deflation in the UK, as Matthew Furniss, senior consultant at Punter Southall, points out.

‘Deflation is clearly of concern to the UK economy as a whole but, surprisingly, can actually impact pensioners favourably thanks to their spending habits and the way that both company and state pensions are calculated.’

The state pension is pegged to RPI, but although any increase comes in during April,
the amount is set according to the RPI figure for the previous September. This year, pensioners will benefit from last September’s record high of five per cent and the basic state pension will increase from £90.70 a week to £95.25.

Company pensions are generally protected from deflation as they cannot normally be reduced and a proportion of pensions are increased by fixed percentages, normally between 2.5 per cent and five per cent per year.

Seeking diversification
However, those investors who have built up a pension fund to augment their retirement income are faced with a dilemma. For investors worried about the impact a sustained period of deflation will have on their portfolio, Gavin Oldham, chief executive of The Share Centre, suggests they seek a low level of interest and less risk-based investments.

‘If your biggest fear is deflation, then you should keep everything in cash or as near to cash as you can and although banks may not be paying much in the way of interest, at least it keeps its value. You could also look at holding bonds and get a little bit of interest without taking too much risk,’ he says.

‘Over the very short term, I think deflation is a problem, but in the medium term, there is so much money out there that once the pump starts moving again, we may well see a period of inflation, at which point equities and real asset investments will create value.’

Fanning the flames
However, many commentators are rightly concerned that the now numerous government stimulus plans, particularly plans that involve printing new money, are storing up trouble ahead in the form of inflation. With the recent implementation of quantitative easing, both in the UK and the US, we are now moving into unknown territory.

Since the announcement of the raft of quantitative easing measures, the yield on 15-year gilts – which are used as the basis for calculating the annual amount an individual can take from a pension fund – has fallen to 3.25 per cent, compared to 4.25 per cent a year ago and 4.50 per cent in 2007.

Similarly, individuals buying guaranteed annuities have seen rates fall by ten per cent since the middle of last year and incomes from drawdown and conventional annuities have fallen significantly.

‘With the economy in such a volatile state right now, and with no concrete guarantee that we won’t see further swathes of quantitative easing in the future, retired people are suffering significantly and those approaching retirement are in a bewildering position,’ warns Vince Smith-Hughes, head of business development at Prudential.

The high price of retirement
He explains that ‘Falling gilt yields mean less money for individuals approaching retirement considering income drawdown and they may begin to feel a bit like the walls are closing in on them as far as their retirement income options are concerned.’

According to Alliance Trust’s ongoing monthly study of age-related inflation, those over the age of 75 face an inflation rate which is much higher than the official rate. This age group has benefited from the decline in gas and electricity price inflation, but still faces an inflation rate which is 53 per cent higher than the official headline rate and 75 per cent higher than the inflation rates facing both the under 30s and 30 to 49 year olds.

Shona Dobbie, head of the Alliance Trust Research Centre, argues, ‘We are concerned that the inflation rate facing the two oldest age groups is much higher than the official rate of inflation, and much higher than the inflation rate facing the other age groups. The elderly are simply not seeing the same benefits of falling prices as the young.’

The Share Centre’s Gavin Oldham, concludes, ‘Both inflation and deflation are impostors, and we should approach them with care. Inflation is the catalyst whereby borrowers steal from the lenders, and deflation is the catalyst whereby lenders steal from borrowers. Which is feared most? Probably deflation, as it discourages risk taking and postpones consumption. But inflation is a scourge on prudence, and causes great damage to the weakest in society, including the old.’