Deflation – it’s official!

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What is Deflation?

A deflationary climate has returned to Britain for the first time in nearly 50 years.

The Retail Prices Index (RPI) measures a theoretical basket of goods and compares changes in the price of the whole basket over time. For the first time in five decades RPI was lower over a 12 month period.

In March 2009 RPI was 0.4% lower than 12 months earlier in March 2008. In the short-term delfationary pressures could make the recession we are currently going through worse than expected as the general level of prices continues to fall.

Some people argue that falling prices is generally good for consumers, and therefore the economy, however if these deflationary pressures become entrenched over the medium term then this will actually hurt the economy as consumers will effectively stop buying products today in the hope of even greater savings to be made tomorrow.

The Office of National Statistics has said that the largest constituent part of the “basket” which has pushed prices lower was gas and heating oil bills, with falling vegetable prices over the last 12 months also making a contribution.

Aren’t Falling Prices a Good Thing?

Not necessarily as it affects some consumer groups more than others. For example, pensioners receive a State Pension which is linked to RPI – they are therefore seeing little increase in the value of their State pensions. To compound the problem, the basket of goods which the average pensioner purchases is rising in price above inflation – in real terms therefore pensioners are becoming worse off.

Pensioners who depend on their savings for additional income over and above their pension income are also suffering at present from low interest rates on their savings accounts.

Pensioners are likely to see their pensions increase by no more than £2.40 per week next year. State pension increases are set with reference to RPI figure in September which was 2.5%. The likelihood is that State pension will increase by £2.40 per week to £97.65.

The other losers in a deflationary economy are those burdened with debts – they will suffer with the debt-deflation trap – which would see the “real” value of debts increasing as the general level of prices of all other items falls.

Deflation will also affect workers as they are unlikely to receive wage increases – business owners and managers will argue that the deflation of prices in the economy is providing a boost to “real” wage values without the need to put their hands in their pockets.

 

RPI and CPI

The Government’s preferred method of measuring prices is through CPI (Consumer Prices Index) which again uses a theoretical basket of goods and considers the change in prices of these goods and the relative weightings of each good sector within the basket. CPI excludes housing and mortgage costs.

At present CPI is running still in the positive at 2.9% per annum.

The Rule of 72 – The Time Value of Money

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Introduction

The Rule of 72 is a great way to help plan for the future. It is a quick and easy method for calculating the impact that growth and inflation can have on your money and other investments.

Compound Growth/Interest

The rule can be applied to investments where the investor is enjoying compound growth. Compound growth, in its simplest terms applies in cases were “money makes money”.

For example, with a savings account you receive an annual interest rate (return) and for the sake of this article we will consider the scenario where you invest £1000 into a savings account and leave it for a number of years with it enjoying an interest rate of say 5% net (those were the days!)

After year 1 your money will have grown to £105.00 (£100 plus 5%) – at the end of year 2 your money will have grown to £110.25 (£105 at the start of year 2 plus another 5% interest. This is COMPOUND INTEREST – your money has earned money – the £5.00 interest received at the end of year 1 has itself earned 5% interest; in this case the £5 has earned 25 pence interest.

The Rule of 72 – how to use it

To work out roughly how long it will take for a given investment to double in value, simply divide the interest rate being received into 72 – this will give you the length of time required for money to double in value.

For example, of you are receiving 6% net interest per annum your money will double in value in 12 years (72/6 = 12 years).

Likewise, the same principle can also be used to calculate the effect of inflation (increase in the cost of living) to halve the value of your money – e.g. if inflation is running at 3% per annum then your money will halve in real value (it’s purchasing power) in 24 years.

Why is this Principle important?

When planning your finances for the future you need to make a number of assumptions about how finances will change over time. Retiring today on £20,000 per annum pension may be comfortable for many people – but if you retire on £20,000 per annum in say 50 years time then the purchasing power of this income will be considerably less if the cost of living rises steadily over the next 50 years.

If you were to make an assumption that say inflation was to run at an average of 4% per annum then the real cost of living doubles every 18 years.

This is important for anyone planning to build a portfolio of assets over the longer term. In this example, consider someone age 29 – if we assume inflation of 4% per annum the cost of living will have quadrupled between now and retirement at age 65.

If the 29 year-old considers they can comfortable live on £25,000 if they retired today with all mortgages and other debts repaid by the time they retire, then by the time they reach 65, assuming 4% inflation, their portfolio will need to provide them with £100,000 per annum to maintain the same standard of living.