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Comment: Inflation-Linked Savings - Smoke and Mirrors

Comment: Inflation-Linked Savings - Smoke and Mirrors
Date of Publication: Thursday, 24 November 2011 00:00

There have been some significant moves in the market for savings products this week, driven mostly by concerns about inflation.

 

Santander has looked to muscle into the space vacated by NS&I, who announced a withdrawal of their popular inflation-linked Investment Accounts in November. Following their self-acclaimed ‘revolutionary’ up-front interest bond, Santander’s Inflation-Linked Savings Bond pays the rise in the Retail Price Index over a six-year period.

 

NS&I’s erstwhile partner, the Post Office, yesterday withdrew issue three of its Inflation-Linked Bond with immediate effect. The Post Office’s previous issue, a generous five-year bond which offered RPI inflation plus 1.5%, was withdrawn in September, and a less generous ‘issue three’ followed in early October. Nevertheless, demand has remained popular and the Post Office has now pulled the plug on the deal owing to ‘extremely strong demand’.

 

Consumers have been understandably keen to link their savings to inflation and ensure themselves against further real losses.

 

What this means, however, is that inflation has become intrinsically linked to savings. No longer is it a mere contributory factor to decision-making; it directly affects the return.

 

It may dismay many, then, to learn of the very real possibility than inflation is likely to tumble next year, dragging down the value of all index-linked savings products.

 

The minutes of the Monetary Policy Committee’s November meeting released this week revealed a consensus among members that inflation should fall below target in 2012 – that is, on or below 2%.

 

The Committee has long attributed this year's high inflation to temporary measures, such as the rise in VAT, higher energy prices, and higher export prices, rather than monetary policy and consumer-driven spending.

 

However, inflation is set to fall back sharply in the early stages of 2012 when the impacts of the fixed VAT amendment drop out of the twelve-month comparison. Furthermore, oil prices and export prices would need to rise as much again in 2012 as they have done in 2011 to sustain inflation at 5%+.

 

Fundamentally, inflation is expected to reach its target as these temporary impacts are negated throughout the year.

 

A fall in inflation could be limited if companies attempt to rebuild their profit margins aggressively. But it would seem unlikely that firms are willing to upset a precarious balance while consumers are still smarting from one of the tightest squeezes in living standards in living memory.

 

Moreover, the slackening in long-term productivity could mean reduced inflationary pressures through supply-side measures as the economy recovers. High rates of unemployment are likely to mean low real wage growth at the bottom end of the sector. Demand-led measures may not be conducive to inflation either. The MPC would prefer, it seems, to see inflation fall than support further “quantitative easing” measures at this time.

 

This is not to say, of course, that inflation could not stay its course. Were the MPC to backtrack, extra money could lead to house prices rises while housing stock remains in short supply. Uncertainties surrounding the Eurozone continue to strangle the market, and measures to save the weakest member nations increases inflationary pressures on the strongest. But the possibility for UK inflation to fall remains, and six years is a long time to hinge bets on an entity that even the monitoring body cannot accurately predict.

 

Smoke and Mirrors?

Were inflation to fall on or below target for 2012, the most that an index-linked product would offer is the Post Office’s older five year product, (c. 3.5% gross), with the funds still untouchable until 2016.

 

Could savers soon begin to see their cherished index-linked products begin to sink below current shorter-term ISAs and fixed-term bonds? Though it may seem unlikely, it's not impossible.

 

Inflation-linked bonds have seduced through high inflation rates and consumer determination for protection against real losses. But beating the level of inflation does not automatically mean the best market rate.

 

For long-term investments, Scottish Widow and Vanquis’ five-year fixed-rate bonds pay 4.60% and 4.65% AER respectively (which would require inflation to measure well over 3% on average over the next five years to compete).

 

Vanquis’ upgraded two-year bond today hit the top of the chart at 4.05%, showing admirable competitiveness for a shorter term investment. With uncertainty prevalent, savers are left with a whole new set of dilemmas.

 

Oranges are not the only fruit, as we all know all too well. Inflation-linked savings may well prove to be no more than smoke and mirrors in the long run too.

 

Keith McDonald
Which4U Editor

Thursday, 24 November 2011 00:00
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