Will a falling pound cause sky-high inflation?

Should you worry about increasing prices due to a weak pound?

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

The main financial news story of recent days has been the falling pound. It’s now at an all-time low versus the dollar at £1/$1.22. Looking ahead, it could go even lower due to declining confidence in the UK economy, a US interest rate rise that may cause the dollar to appreciate and an ultra-loose monetary policy pursued by the Bank of England. Will this cause inflation to soar?

A weak currency causes imports to become more expensive. This has started to become evident this week as the standoff between Tesco and Unilever has dominated news headlines. Unilever is attempting to raise prices by a rumoured 10% because it says that its costs are now higher. In response, Tesco isn’t restocking Unilever goods since it apparently doesn’t wish to pass on the price rise to customers for fear of becoming uncompetitive versus rivals. Nor does it wish to bear the higher cost itself, which would be to the detriment of its own financial performance.

To pass on costs or not to pass on costs?

The situation between Tesco and Unilever is one likely to be repeated in a range of industries. That’s because imports are inevitably now more expensive than prior to the EU referendum. The impact on inflation is down to whether the companies that experience higher costs choose to pass them on to consumers in the form of higher prices or whether they choose to keep prices as they are and absorb the costs themselves.

For most goods that have a positive price elasticity of demand, the burden of higher import costs could be shared between buyer and seller. This would hurt the financial performance of UK companies that rely on imports and it could also cause inflation to spike in the short term.

However, inflation may not reach sky-high levels. Certainly, an increase from the current level of 0.6% seems very likely, but other factors may keep it at historically normal levels. Among these are UK interest rates, which may have to rise in order to combat inflation. The scope for this to take place may be higher than many investors realise, since a weak sterling provides a boost to exporters. This could have a positive impact on UK economic growth and mean that an interest rate as low as 0.25% is no longer desired.

Furthermore, the world economy is still facing a period of deflation. This has lasted since the credit crunch and it’s a key reason why the Federal Reserve and Bank of England have maintained a dovish stance on monetary policy. A slowdown in China is expected to continue over the coming years and so the impact on inflation of a weaker pound may be offset by global deflationary forces. And with inflation in the UK being near-zero in recent months, it has a long way to go before it reaches a worryingly high level.

So, while the weak pound is likely to stay over the coming months, the level of inflation may not reach troublesome levels. Therefore, the fear it’s creating among investors could be a good opportunity to buy high quality UK-focused stocks at a discount to their intrinsic value.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Peter Stephens owns shares of Tesco and Unilever. The Motley Fool UK owns shares of and has recommended Unilever. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Newspaper and direction sign with investment options
Investing Articles

When cheap markets meet favourable conditions, sentiment flips very quickly

London’s stock market is cheap — some sectors, even cheaper. Given a change in sentiment, the uprating could be substantial.

Read more »

Investing Articles

Empty Stocks and Shares ISA? I’d snap up these 3 stocks to start with!

Sumayya Mansoor explains how she would start to build wealth from scratch with an empty Stocks and Shares ISA and…

Read more »

Concept of two young professional men looking at a screen in a technological data centre
Investing Articles

7.7% yield and going cheap! Why is this unknown FTSE 250 stock flying?

It's no household name, but there's one FTSE 250 stock with a high dividend yield and booming profits that looks…

Read more »

Photo of a man going through financial problems
Investing Articles

I’d stop staring at the Nvidia share price and buy this FTSE 100 stock instead

This writer reckons there is a smarter way to invest in Nvidia today without taking on stock-specific risk. Here is…

Read more »

Young lady working from home office during coronavirus pandemic.
Top Stocks

5 stocks that Fools have been buying!

Our Foolish freelancers are putting their money where their mouths are and buying these stocks in recent weeks.

Read more »

Young Asian man drinking coffee at home and looking at his phone
Dividend Shares

These 3 FTSE 250 stocks offer me the highest dividend yields, but should I buy?

Jon Smith considers FTSE 250 shares with a very high yield, but questions whether the income is going to be…

Read more »

View of Tower Bridge in Autumn
Investing Articles

Is FTSE 100 takeover target DS Smith a great buy?

A mega-merger between FTSE 100 giants DS Smith and Mondi has the City abuzz. But is there any value in…

Read more »

Young Black man sat in front of laptop while wearing headphones
Investing Articles

The WPP share price dips as profits fall. Here’s why it could be a top dividend buy

I'm starting to think the WPP share price undervalues the stock, especially if the long-term dividend outlook comes good.

Read more »