Inflation: Down but not out
Inflation is down, but the threat of rising prices coming back is a real threat to your savings and investments.
For the next year, commentators expect the recession to keep inflation and therefore interest rates, low, despite the Bank of England's efforts on quantitative easing.
But looking further out, do economists see deflation becoming entrenched or savings-eroding inflation instead? And how can you tackle inflation.
Sarah Routledge asks economists to make a prediction and finds out how consumers can protect their savings.
What's the risk?
Inflation is a big risk to savings. Most people only look at their interest rates they are earning and forget the effect of a rising cost of living.
If inflation rises, this decreases the spending power of your funds.
Not defeating inflation is like throwing money away. If the cost of living increases, £1,000 left in an account at zero per cent can buy less than a year ago.
A year ago inflation was over five per cent, now it is down to 1.1 per cent - on the consumer prices index (CPI) scale.
Mervyn King, governor of the Bank of England, warned last week more volatility in inflation would come.
James Hughes, chief economist at Black Swan Capital Wealth Management, believes inflation is "inevitable" - but not just yet.
"Ordinarily when governments print money, sell bonds, nationalise banks and go on an enormous 'quantitative easing' spree, the eventual outcome is inflation.
"However, the UK's problems, comprising a massive budget deficit, ageing population, unsustainable welfare system and uncompetitive exchange rate, are so deep and fundamental that the increased money supply is not yet feeding through to prices, and may not do so for some time.
"In fact, the inevitable inflation may not arrive until sterling weakens further and the rest of the world economy starts to recover rather more impressively."
He warned inflation may be low to zero for up to the next two years, but could then very rapidly rise into double digit territory, "just like the late 1970s - and for many of the same reasons".
However, economist Howard Archer, from Global Insight, is feeling more optimistic.
"I am fairly relaxed about inflation over the long term," he says.
"There is substantial excess capacity in the UK and I think growth will be muted for an extended period, particularly given the amount of fiscal tightening that will have to occur over the medium and longer term.
"Therefore I believe that underlying inflationary pressures will remain contained."
Strategies
Adrian Lowcock, independent financial adviser for Bestinvest, says investors should consider which inflationary scenario is most likely in order to protect their assets over the next few years.
"We do not think deflation is a long term issue with stimulus policies like the VAT cut expiring being an important driver of inflation in January both CPI and RPI."
A weak pound and rising oil prices will also contribute to rising inflation by early next year, Mr Lowcock adds.
All these short-term pressures will lead to consumer expectations of high inflation. Whether this starts to become a problem will depend on the Bank of England's reaction, Mr Lowcock believes.
"As the Bank of England follows such indicators it is possible they will react to this and raise interest rates, however we believe that this is unlikely and the market should know all of this, however not everyone will look through the short term issues and we could see some over reactions to the figures.
"Our view is inflation will return next year and this is the low point, however we do not believe inflation will remain an issue over the medium term."
If inflation is a concern, consider holding Index Linked Gilts, Mr Lowcock suggests - these are particularly attractive for 50 per cent taxpayers as the uplift to compensate for inflation is not taxable.
Gold is often referred to as an inflation hedge because over the long term the price of gold has stayed the same, once inflation has been factored in.
"However, volatility in the asset class has been more pronounced in recent years," Mr Lowcock warns. The price of gold has hit record highs recently as investors concerned about the direction of the stock market pile into 'safe havens'.
"Real assets such as commodities and land would be attractive. Equities investing in these areas and for growth would also appeal," he adds.
Tom McPhail, independent financial adviser for Hargreaves Lansdown, believes inflation will stay low until the economy recovers - but no-one knows when that may be.
"In the meantime, long-term investors can look to real assets such as shares and property to offset inflation, also National Savings and Index linked Gilts.
"For retiring pension investors some inflation proofing is a very good idea, there is nothing to stop you splitting your pension fund to buy part inflation proofed and part level income."
Retirement
High inflation is certainly more of a risk on a fixed income and for those coming up to retirement, now is the time to start planning.
Bob Bullivant, chief executive of Annuity Direct, says the main decision for people approaching retirement is whether to take a fixed-level annuity or an inflation-linked annuity.
A fixed-level annuity starts from a higher point than an annuity linked to the retail price index (RPI), which follows inflation. After ten years or so, the inflation-linked annuity will catch up and start to overtake the fixed-level annuity.
"But what most people want is the money early on in retirement, when they are going to be most active," says Mr Bullivant.
If this is the case, Mr Bullivant recommends having a pot of savings to compliment a fixed-level annuity, so when inflation begins to erode the value of your pension you can top it up with income from an ISA or savings account.
"That way you can get the maximum benefit from your annuity early on, then if you need more money later, that's when you can draw down income from an ISA."
It is also possible to do this the other way round, by topping up your inflation-linked annuity in the early years of retirement with savings, but this would mean less cash is available to pass on as an inheritance.
And don't forget, an RPI-linked annuity follows the RPI: "So if the RPI goes down, so does your income."
On top of this, the inflation rate for pensioners, who usually spend more of their income on energy bills than the rest of the population, is often higher than the RPI would suggest.
There is no easy answer for choosing an annuity - it is crucial to talk to a qualified, chartered adviser who specialises in retirement planning, Mr Bullivant says.
Inflation may be low now but there is no reason to be complacent.
Looking at your savings and investments now, before inflation becomes a problem, could help protect your hard-earned cash from rising costs of living.
Although fixed-interest accounts with a high interest rate and long-term savings bonds may look like a good deal now, be careful that you are not locking all your cash away as the picture may look very different in five years time - consider spreading your assets and get advice if you are concerned.
Defeating inflation is hard, but it can be done.
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