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Thursday, August 19, 2010

Beating inflation safely

Republished from the Broad Oak Blog:

UK investors who are concerned about the threat of inflation have recently (19 July) lost access to an ideal solution, the NS&I Index-Linked Savings Certificate. Now a building society is offering something to fill that gap in the market.

National Counties are marketing an index-linked cash ISA. This is not quite the same as NS&I's product, because the investment is for a fixed amount (the maximum cash ISA allowance, i.e. £5,100) and no withdrawals are permitted within the 5-year term of the plan. As with NS&I, the return is linked to the Retail Price Index (RPI), plus 1% p.a. For further comment by Citywire, see here.

A lot depends on what you think may happen in terms of inflation, which brings us to the great inflation-deflation debate. Some commentators are saying that Western economies are so indebted that we have reached a turning point and people will spend less and save more (or pay down debt, which amounts to the same thing). Governments are going to have to follow suit, and the UK government is currently busy trying to demonstrate its commitment to do so, fearing that bond markets may lose confidence in our financial management and will then charge higher interest, which would really put us in a pickle.

So demand is reducing. We see this in the recent bankruptcies of UK holiday companies and the pages of cut-price cruise adverts in the middle-class press. If this is the pattern generally, then holders of cash will benefit as prices reduce - the pound in your pocket will grow more valuable, quite safely. Even better, this type of deflationary gain is not taxed, at least not until the government nerves itself up to simply confiscate your savings.

But that's not the whole picture. While demand for luxuries is lessening, there are other things that we still have to buy, especially food and energy. Here, prices are rising. And if interest rates do rise, that will also increase RPI, which unlike the Consumer Price Index (CPI) includes housing costs. So it is quite possible that inflation as measured by RPI could be high, even as the economy slows down. It's worth noting that the government has recently changed rules on private sector occupational pensions so that their benefits will increase in line with CPI instead of RPI, which suggests that our rulers believe that one way or another, RPI will rise faster than CPI in years to come.

The BBC appears to have bought the official line that we should ignore food and energy costs, referring to CPI as "core" inflation and noting that it's now a mere 3.1%, as opposed to RPI which is running at 4.8%. However, unlike the mandarins at Broadcasting House, the rest of us need to eat and keep warm; or, to be a little fairer, food and energy is a more significant part of most people's budgets than it is for the upper echelon of the mediaocrities.

An RPI-linked cash product is a good each-way bet: if prices do reduce, then your money becomes more valuable; if prices increase, the value of your savings is preserved; and either way, you benefit from that extra 1% p.a. sweetener.

Reasons not to? You may find you need access to cash within the 5 year term; and if you're a gambler, you may be looking at investments that could outpace inflation (think of the current fever for commodities such as gold, silver, oil and agricultural products). But you shouldn't put all your eggs in one basket, and most ordinary people aren't gamblers when it comes to their nest-eggs, so this product is worth a look.

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