UK CPI inflation hits three decade high of 5.5% - the big squeeze continues

Jason Hollands, Managing Director of online investment service Bestinvest comments:

"The latest UK inflation data - released this morning – has revealed that the annual rate of Consumer Price Index inflation in January came in at 5.5% - up from 5.4% previously.

"Increased goods prices were a key driver of this with food and non-alcoholic beverages rising by 4.3%, a surge in clothing and footwear increasing 6.3% from a year ago and furniture, household equipment and maintenance increasing a whopping 8.4%. Transport costs increased 11.3%, owing to the supply chain constraints disrupting new and used vehicle prices. Electricity, gas and other fuels prices rose 7.1%.

While the rise was only slight compared to a month earlier, this was a seasonal effect. Further and material increases in inflation are almost certainly coming, in part due to the lifting of the cap on energy bills – so the thumb screws are going to continue to tighten over the coming months, with the Bank of England forecasting inflation will hit 7% by easter.

While wages are also rising – with average pay (including bonuses) up 4.3% in the final quarter of 2021 – earnings rises are lagging inflation and on the near horizon households have higher taxes in the form of National Insurance increases to contend with too. The combination of rising prices, higher taxes, rising borrowing costs and lagging wage growth are going to squeeze many household finances over the coming months.

"On the positive side however, the UK economy is in decent shape. The UK economy grew 7.5% in 2021, the highest level of growth since the second world war. Unemployment remains low at 4.1%. While there are undoubtedly near term challenges, the outlook should not be seen as overly gloomy.

"As surely as night follows day, higher inflation leads to higher interest rates as central banks seek to tame rising prices. Today’s data reinforces expectations of further interest rate hikes by the Bank of England, which has already raised rates twice since mid-December. Bank rates could reach 1.25% by the end of the year.

"A key message to savers and investors is that beating inflation should be a key objective – that is no mean feat when the Bank of England forecasts inflation to rise to 7% by easter. Standing still means you are getting worse off in this environment as inflation gnaws away at the spending power of your wealth. When inflation is factored in, cash returns are deeply negative, as are government bond yields with 10-year gilts currently yielding 1.58%.

"I would urge people to think about whether they have the right balance between cash savings and longer-term investments. While it is very wise to keep a cash buffer for short-term needs and emergencies, holding too much cash for long periods of time will see the real value of this wealth eaten away by inflation.

"Inflation and its bed fellow higher borrowing costs, also have ramifications for investors too and we are now clearly in a very different environment to the one that investors have been used to for more than a decade.

"Bond yields have moved much higher in recent months and growth sectors – such as technology stocks – that were the winners of recent years have taken a real battering since the start of the year as their sky high valuations get reassessed against the prospect of tighter monetary policy and greater uncertainty about the valuation of projected future earnings in today’s money.

"In contrast, unloved banking shares have a spring in their step as rising interest rates hold out the prospect for much higher profits to be made on lending activity. Energy and commodity prices have surged too as key components of inflation. After years in the doldrum, overshadowed by tech and online businesses, “Old Economy” stocks are fighting back. These are all sizeable sectors on the UK stock market, which has enjoyed a much stronger start to 2022 than the US or global equities generally, reversing the pattern of recent years when it has been a bit of a laggard because of its low exposure to areas like technology. Investors who have shunned the UK market in recent years, might therefore reassess this.

"Two concerns are stalking the markets at the moment – aggressing tightening of monetary policy by central banks and a potential conflict over Ukraine which would be a geopolitical shock and likely prompt further increases in energy prices. A typical response to a crisis would be for central banks to boost liquidity by loosening policy, but with inflation so high their credibility is on the line and so they may not come riding to the rescue when inflation is running wild. If there is tangible evidence of crisis over Ukraine easing, this will certainly calm investor nerves."