It used to be really easy to understand the markets. You could read sentiment and marry that with reasonable economic data but today it’s a great big bun fight that makes it suitably complicated for some.

Why do we have inflation when most countries are fighting their way out of a depressive state, when the world's biggest economy is still knackered, and when the average consumer doesn't know the impact or detail of the next big cut?

It's all a bit complicated so I will try and make some sense of the noise that I am bombarded with every day.

Who would inflation suit? Inflation will suit anyone with a large debt/deficit. That will be the UK and the U.S. I suppose. Inflation effectively erodes the value of the debt. For example, inflation at 100% effectively means the debt is worthless. And so controlled inflation would be good.

But if inflation is a threat wouldn't you need to increase interest rates which would kill off the UK and the U.S. as they are so much in personal debt? Yes it would. So it's surprising that the Bank of England and Fed are not that bothered, it seems, about inflation at the problematic levels they are.

But they still keep talking about inflation and the potential for deflation when everything is more expensive than it was before? Yes that's true and it's puzzling. I can see that we should have deflation, after all, we are all worried about cuts and we are all paying down the debt we have rather than spending, so yes we should have deflation.

Deflation would be bad for business/equities and more importantly bad for the UK who would effectively have a debt that's increasing. And so, quantitative easing (wrongly referred to as printing money) is introduced.

It's supposed to be effective in reducing the cost of borrowing money but there is little evidence of that. It has however, been effective in driving down the image and value of sterling which amazingly has two benefits for the UK: Holidays abroad are more expensive for us, so we stay here, and holidays here are cheaper for tourists who come and spend; Exports are cheaper and imports are more expensive so it balances out the numbers, but also, because imports are more expensive, it creates a bit of inflation which helps reduce the debt via inflationary means. Exports and also tourism are all very acceptable to any economy as its all new money. Life's good. Bored? You shouldn't be!

So where is inflation coming from? Apparently it's raw goods, metal, oil etc. Hmmmm, how's that work then? Everyone's worried about Armageddon yet raw goods are rocketing in price? That's a puzzler. So, how can raw goods be worth more when demand is less?

So, I will refer back to this column in 2008 where I called the 'deflation' bomb and contradicted Goldman Sach's view on where oil would be going. In the column I showed that the total amount of capital invested into index traded strategies into commodities equalled $13bn in 2003. This is the maximum it had ever been. If in 2008 it had been $16bn it would have been a marked spike. Instead, the number was a staggering $260bn. All demand for the actual commodities was neutral or negative so prices should have been falling.

Apparently the laws had been relaxed which allowed for investors to buy commodities on margin i.e. instead of paying $100 for $100 oil or wheat, you could put down just 8% of the trade i.e. $8. Therefore you could achieve a twelve times exposure to a market if you wanted.

Investors were also allowed to gain exposure to commodities by investing via what's called an over the counter swap, i.e. you effectively can hide positions you are taking in commodities. So with all the talk about bashing the banks/governments that were doing it, what has the actual action been? None!

And so, the aforementioned can create their own inflation, we pay more for our goods and the economy is rebalanced at our expense through inflation. Marvellous eh?

If you have a financial query call Peter on 0845 230 9876, e-mail or take a look at our website

The value of shares and investments can go down as well as up


Michael Masters

Peter McGahan is an Independent Financial Adviser and the Managing Director of Worldwide Financial Planning Ltd who are authorised and regulated by the Financial Services Authority. 'The FSA does not regulate Credit Cards, Will Writing and some forms of mortgage and Inheritance Tax Planning.'

Information given is for general guidance only, and specific advice should be taken before acting on any suggestions made.
The above represents the personal opinions of Peter McGahan.
All information is based on our understanding of current tax practices, which are subject to change.

Comment Here!