Comment: Inflation skimming our savings by stealth

Now imagine this compounding in reverse. Take a lump sum, allow for the compounding effect of inflation, and over a working lifetime the real value of your investment can shrink to almost nothing.

It couldn’t happen here – could it? Desperate governments have proposed few more audacious raids than that floated in Cyprus last week for a direct grab on bank deposit and savings, causing a mass outcry. We gasp in horror at the prospect of anything similar happening to our savings here. But they are by no means free of risk.

The one virtue of the proposed Cypriot bank raid was that at least it was explicit. Here we are falling victim to a slow motion erosion by stealth. The effect of inflation at 3 per cent plus a regime of ultra-low interest rates – compounding in reverse – means savers have lost at least 10 per cent of the real value of their capital in recent years.

The loss resulting from the cumulative effect of inflation on savings since the Bank of England slashed rates to 0.5 per cent has been estimated at £43 billion. According to calculations by Yorkshire Building Society, the average saver has lost £2,500 in real terms since the credit crisis began.

How ironic, then, that the response of the giant investment institutions and pension funds to the financial crisis has been to pile into government gilt-edged stock – when the yield on gilts has fallen to its lowest in the history of the Bank. Many investors appear innocent of the prospect that they may lose most, if not all, of their capital in real terms after allowing for inflation.

I am grateful to Charteris Treasury Portfolio chief Ian Williams for the following calculations carried in his latest commentary. He cites the example of the current 30-year gilt (UK Treasury 4.5 per cent 2042) currently priced at £122 and due to be redeemed at £100 on 7 December, 2042. If inflation averages 3 per cent a year for the next 30 years, the 100 redemption value will be worth £42 in real terms, a capital loss in real terms from the current price of £122 of 66 per cent.

But if, for example, inflation was to average 5 per cent – something Williams says cannot be ruled out, given the long-term track record of UK inflation – then the redemption value of £100 would be worth £21 – a loss in real terms of 83 per cent.

The current UK Treasury 4 per cent 2060 is priced at 113 and will redeem at 100 in January 2060. If inflation averages 3 per cent a year, the £100 redemption value would be worth £24 in real terms – a loss from the current bond price of 79 per cent. If inflation averages 5 per cent a year, the £100 redemption value is worth just £9 in today’s money – a loss of 92 per cent.

And if inflation averaged 7 per cent a year – a rate closer to what the average citizen feels his own cost of living increase to be – the £100 would be worth just £3 in real terms at redemption. Anything above 7 per cent inflation would virtually obliterate the future inflation-adjusted capital value.

Statistical scare mongering, you may think. No-one seriously believes it could happen. But savers have good reason to be alive to the inflation risk now.

Last week, Chancellor George Osborne give Mark Carney, the incoming governor of the Bank of England, greater flexibility in the inflation targeting remit. But we were firmly assured that the 2 per cent CPI inflation target would remain – as the mortar all around it is being shaken loose, the target itself not having been met for 39 consecutive months. The widespread impression is that the new governor has been given latitude to take more risk with inflation to achieve a higher level of growth.

As for the headline inflation measure, RPI – this has been running closer to 5 per cent a year average. With unavoidable energy and utility bills marching relentlessly upwards, this is the rate that households feel more reflects the day-to-day reality.

Williams notes: “The key rate is the one that most accurately reflects the general rise in prices experienced by the man in the street, not some arbitrary rate constructed up by Whitehall statisticians with half an eye on keeping the indexation of welfare payments down.”

Add to this the prospect of a further dollop of quantitative easing on top of the £375 billion already sanctioned, together with moves to accelerate its entry into the real economy via new lending, and the inflation risk becomes even more evident. In the name of economic recovery, and for unspoken policy purposes, 5 per cent inflation now appears acceptable and 7 per cent a real possibility.

For gilt-edged investors, it all starts to have an ominous 1970s feel to it – gilt prices slumped and yields rocketed then.

That our pension funds are now stuffed with gilt-edged stock under the active exhortation of the Financial Services Authority and in the name of prudence threatens to turn a monetary tragedy into farce. Such is the hidden risk in “safe”, “risk-free” government bond investment.