Blogs | February 18, 2011

Can savers beat inflation?

With food prices soaring and oil touching US$100 per barrel, inflation is rearing its ugly head. Inflation tends to eat away at the spending power of money. So, what can savers do to protect themselves?

Inflation might not be a problem next year
One possibility is: nothing, simply because there might be no problem. If food and oil prices stay at their current high levels but do not rise further, their inflation rates will fall to zero next year. This means that overall inflation will converge towards its "core" rates (calculated by excluding food and energy from the rate of inflation). And these core rates are low. Excluding food and energy prices, inflation is 1.1% in the Eurozone and 1% in the United States. Granted, it's 3% (again, excluding food and energy) in the United Kingdom – but around half of this is due to a higher rate of sales tax (VAT). But let's say you don't believe this, and you expect either continued rises in food and oil prices, and/or higher "core" inflation. What do you do?

Are shares the answer when inflation is high?
It's tempting to buy shares. The thinking here is that if companies raise prices they should also raise profits and dividends, so shares protect us. However, history shows that higher inflation is associated with lower share prices. In the 1970s, late 1980s and in 2007-08, shares fell as inflation rose. There are several reasons for this – one of which could be that investors are irrational. When inflation rises, bond yields rise and so investors should discount future dividends more heavily. But inflation should also raise expected future dividends, leaving shares roughly unchanged. But back in the 1970s, the Nobel prize-winner Franco Modigliani said that equity investors don't act like this. They fail to see that inflation will raise future dividends. As a result, he said, equities suffer the cost of inflation (higher bond yields) without the benefit (higher dividends). This is a form of money illusion. Of course, investors should have wised up since the 1970s. But they haven't. A few years ago, Christopher Polk of the London School of Economics and John Campbell of Harvard University both conducted studies and found investors were still making the same mistake. Polk's paper is here and Campbell's working paper is on the NBER website. The fact that shares did well in 2009 as inflation fell suggests investors haven't learned since.

Gold an opportunity?
If shares are no protection against inflation, what about gold? Again, history suggests no. The correlation between changes in the gold price and in inflation in developed economies is low. For example, gold did badly in the early 1980s when inflation was high, but well in the mid 2000s when inflation was low. Gold prices are so volatile that they could easily fall a lot even if inflation is high.

Cash is king – if the Taylor rule is applied
A more promising hedge against inflation might surprise you – simple cash. The case for holding this was set out in the early 1990s by John B. Taylor, a professor at Stanford University. He said that central banks should set interest rates according to a simple formula, in which a rise in inflation should cause a bigger rise in rates. Higher inflation should therefore mean better returns on cash even in real terms. Sadly, though, although central bankers followed this rule for years, they broke with it in 2008 when they slashed rates to cope with recession. The danger that they might not re-adopt the Taylor rule soon means we can't trust cash either.

Inflation-proofing can carry a cost
This leaves inflation-proofed bonds – described in the eZonomics story What is ... index-linking? – as an option. These investment products certainly protect us against inflation. But at a high cost. Yields on them are almost zero. This is simply the result of supply and demand. Demand for insurance against inflation is high, so prices are high – which means nugatory returns.

Save more and hope
The message here is simple: the main effect of inflation for savers is to worsen their options all round. One way to tackle this is simply to save more. If our money won't grow by itself, we should add to it ourselves. Historically, this is what we have done; high inflation has very often caused increases in savings ratios. Of course, it's painful and difficult to increase savings – especially when the reward for doing so is poor. But sometimes, there are no easy answers, which may be why savers have traditionally hated inflation so much. And why we should hope that central bankers' optimism about it will prove correct.

InvestingPersonal financeInflation

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist