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What rising inflation means for my investments

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Dictionary definition of inflation
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Inflation in the UK continues to rise. For June, it came in at 2.5% on a year-over-year basis. This is the second consecutive month that it has remained about 2%, which is the Bank of England’s (BoE) target rate. 

Will interest rates rise now?

If it stays above this level, the bank will step in and raise interest rates at some point. Increased interest rates would reduce demand for loans. Following from that, the demand for goods and services in the economy will fall too. As demand falls, companies will not be able to increase prices, at least not as fast. This can reduce inflation.

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While interest rate increases help balance the growth-inflation dynamic over time, in the short term it can be bad news for companies. This is because demand for their offerings can fall as rates rise. 

However, for now, this is tomorrow’s problem. The BoE believes that the inflation rate increase is a temporary one, which will settle down as production catches up with the surge in post-lockdown demand. 

Rising costs can impact margins

There is a very real problem at hand, though. And that is rising costs for a slew of companies. From packaging suppliers grappling with rising paper prices to airlines challenged by higher fuel costs, the threat of inflation is increasing. This challenge is compounded by some companies’ lack of pricing power, say, due to price competition. As a result their ability to increase prices is limited even as costs rise. 

In light of this, I would expect to see some softening in profits, while revenues rise. It can also happen that some companies that do pass on increased costs to customers with increases in their prices can see a come off in demand as a result. On the other hand, companies like the oil biggies that are now in a position to pass on higher prices will thrive at this time. 

How I would invest now

If I made short-term trades, I would be tempted to buy and sell based on current inflation rates. However, that is not the Foolish philosophy. It is often a good idea to hold a stock for a long time to truly derive big returns from it. For that reason, I would not worry too much about a quarter or two of weakening in profits as costs rise. Over time, inflation can even out. This in turn is likely to be reflected in companies’ profits as well.

I would worry, however, if inflation rises so fast that it completely derails companies’ profits. Or if it continues to be persistently high. If it does, then it runs the risk of derailing the economy itself and sending it reeling back into slowdown. I do not think we are anywhere close to that point yet. But some economists believe that the threat is very real, so I will keep track of inflation numbers. And if the rise is persistent, here is how I would protect my portfolio.

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Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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