If the majority of your wealth is in cash, inflation is your greatest enemy.
In the last few years the interest paid upon cash deposits has been slashed to the bone. As a result, anyone who relied upon their interest from their bank and building society accounts has seen their income collapse to a fraction of what it used to be.
Some savers, in order to increase their income, have ventured into bonds and shares, but many still choose to keep most or all of their money in deposit accounts.
Unfortunately deposit accounts are being hit again as inflation has returned with a vengeance.
Public enemy number one
It's no secret that many governments have chosen to inflate away their debts; the current favourite way of doing it is via "quantitative easing".
But the result is just the same. Inflation eats away at the real value of deposit accounts (and any other assets). It's a pernicious way of transferring wealth from owners to debtors.
As Milton Friedman put it, "Inflation is always and everywhere a monetary phenomenon."
Warren Buffett on the inflation tax
Warren Buffett made a devastating critique of inflation in his article from 1977, written for Fortune magazine. The key section is shown in full below:
"The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital.
It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation or pays no income taxes during years of 5 percent inflation.
Either way, she is 'taxed' in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax but doesn't seem to notice that 5 percent inflation is the economic equivalent."
It eats your cash
The current rate of inflation, as measured by the retail prices index (RPI), is 4.8% a year. Let's say that your money is in a "higher rate" deposit account (the quotation marks are ironic) you might be getting 2.8% gross, or 2.24% net if you're a basic rate taxpayer.
At these rates a basic rate taxpayer is guaranteed to lose 2.45% of the real value of their money over one year. So this account turns £10,000 into £10,224 but after allowing for inflation its real purchasing power is £9,755.
In the same period a debt of £10,000 is reduced to £9,542 in real terms. No wonder that some people love inflation!
Real assets
The best way for cash investors to protect themselves from inflation is to diversify away from cash into real assets such as shares, property and inflation-proofed investments such as National Savings index-linked certificates and index-linked gilts.
Many investors choose to hold gold, though the link between inflation and gold isn't as strong as it used to be. As this article from Bloomberg points out, a gold price of $2,000 an ounce is still some 53% below its inflation-adjusted peak in 1990
The ideal scenario
What cash investors want more than anything else is a good old burst of deflation, as Japan has experienced for much of last twenty years.
Unfortunately policymakers will do everything to stop this, because deflation encourages people to hoard cash and defer spending until the future when everything will be cheaper!
More from Tony Luckett:
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