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Inflation: An investor’s best friend

Last updated: 9th June 2022

I often describe inflation as the most powerful financial force that nobody ever thinks about. Working by stealth, it produces annual changes you barely notice – but which over the long-term can either make you poorer, or can supercharge your wealth if you learn how to harness it.

As a property investor, if you don’t understand inflation you’re ignorant about one of the most important forces that’s acting on your investment whether you know it or not – and as a result, you’re not using it to your advantage.

In this article you’ll learn:

  • What causes inflation over the long term (it’s probably not what you think)
  • The devastating effect inflation can have on your savings, even over a short period of time
  • How property investors can turn inflation into a valuable wealth-generation tool

So let’s get into it…

What is inflation?

When you hear people talking about inflation, they normally mean the rate at which the cost of goods and services is increasing each year. This is measured using something called the Consumer Price Index (CPI), which calculates the cost of a representative “basket” of products. So if someone says “inflation was 2% last year”, they mean that the cost of goods and services has increased on average (as measured by the CPI) by 2%.

We tend to take it for granted that prices do go up each year. But why? Wouldn’t you expect prices to actually fall over time as we get more efficient at producing goods? This is an important question that we’ll come back to later.

First though, there are two other types of inflation worth understanding.

One is asset price inflation. The price of assets – like property, shares or gold – aren’t included in the “basket of goods”. It’s therefore possible that asset prices are changing at a completely different rate from the consumer prices you’ll typically read about.

Clearly, this is an important type of inflation for property investors to understand, so I’ll be giving this a lot of attention later on.

Finally, there’s monetary inflation. This means an increase in the amount of currency in circulation. If there was £100bn circulating in the economy last year and there’s £110bn now, there’s been 10% monetary inflation. It’s not immediately obvious why this matters or what the effect would be – but as we’ll see, it explains a lot about what’s happened in the economy over the last decade…

How do governments feel about inflation?

Most major governments have an explicit policy of targeting a moderate amount of inflation: in the UK and US, they target 2% per year.

Why? Because they’re fearful of the opposite: deflation, meaning prices falling over time. They believe that if prices are falling, people will delay their spending plans: after all, why would you buy something today if you believed you could get it for less next month? This creates a spiral of falling demand which is bad for the economy.

On the basis that deflation is harmful, it’s safer to aim to over-shoot and still avoid deflation if you fall short, rather than to aim for 0% and risk under-shooting.

(Rather conveniently, inflation also has the effect of making it easier for the government to repay its debts – something property investors can take advantage of too.)

How do governments control the level of inflation anyway? We’ll find out later on.

What causes inflation?

We need to divide inflation into short-term and long-term, because each are completely different – and many people misunderstand the impact of inflation on their investments because they don’t understand this difference.

Short-term inflation

Short-term inflation is caused by shifts in supply and demand:

– If supply falls and demand is constant, you’d expect prices to rise because the same number of people are competing for a smaller amount of goods. Producers increase prices to the point that some buyers drop out of the market and bring the market back into balance.
– If demand grows and supply stays constant, there are more people in the market competing for the same amount of goods – producing the same effect.

We’re seeing a great example of short-term inflation in action as the world opens up again after the Covid pandemic:

– People as a whole have more savings than they did before the pandemic, increasing demand as they can now spend it again
– At the same time, supply has fallen because global supply chains have been disrupted, and there are shortages of key input materials like electronic components, lumber and concrete

For property investors, a period of inflation in the short-term doesn’t make a great deal of difference:

– On the plus side, it puts upward pressure on wages – which could eventually translate into the ability to pay higher rents
– On the downside, it increases the cost of materials so squeezes margins on refurbishment projects

But really, it’s over the long term that inflation has a major effect on property investors – and indeed, on everyone else.

Long-term inflation

Long-term inflation isn’t just bouts of short-term inflation repeated again and again. Over the long term – by which I mean a decade or more – what we call inflation isn’t just the cost of goods going up…it’s the value of the pound you measure prices against going down.

This takes quite a bit of wrapping your head around at first, because we tend to think of the pound as having a fixed value. But if you go into a supermarket and your £10 note would buy you less of every single product than it would have done a decade ago, it’s probably not because the cost of producing every single product has gone up: it’s because something has happened to the value of your £10 note.

That “something” is millions of extra pounds being created: the monetary inflation I referred to earlier. When more pounds are circulating in the economy, the value of each existing pound falls.

The easiest way to explain this is by thinking about pizza, which conveniently is one of my favourite things to do anyway.

Imagine a completely closed economy that contains nothing but you, three friends, four coins, and a pizza. You each have one coin, so you conclude that each of you has a claim to one quarter of the pizza. However, a mysterious stranger then appears, gives you each another coin, then disappears again. Now if one of your friends was particularly hungry and wanted to buy your quarter of pizza from you, you’d want two coins from them – or maybe you’d sell them an eighth for a single coin.

The pizza hasn’t become any bigger, but each coin has become worth less as a result of more of them being added to this strange little economy.

This is exactly what happens over the long-term in the economy: more pounds created means the value of each existing pound falls. It therefore requires more pounds to buy anything…so the “price” of everything has gone up, but not for the reason it first appears.

Of course, this is simplified. In reality, it’s nowhere near this neat: there are a million other factors affecting prices, and there’s no fixed relationship like “increasing the amount of money by 10% increases prices by 5%”. But the general principle holds, and we can see evidence of it by looking at purchasing power over time.

Where did your purchasing power go?

We can see evidence of this by looking at a chart showing the “buying power” of £100, all the way back to when Queen Victoria took the throne in 1837:


“Buying power” means what value of goods you’d be able to buy at different points in time with 100 pounds you acquired in (in this case) 1837. If you have less buying power over time, that’s another way of saying there’s been inflation.

Let’s look at a few key points on this chart;

– £100 of buying power in 1837 still had £100 of buying power a lifetime later in 1914
– By 1950, buying power had plummeted to £30 – a loss of two-thirds in just 36 years! What had happened between those two years? Two world wars – which involved a huge amount of money-creation
– By today, the same amount of money that would have bought you £100 worth of goods in 1914 would buy you…85p

That’s a £99 loss of purchasing power!

Although that’s an unbelievable drop, it still sounds like a long stretch of time – so you might find it even scarier that the equivalent of £100 in the year 2000 would buy you £56 of goods today.

That’s nearly half of your purchasing power gone in a little over 20 years! This is why inflation is so important to understand: you barely notice it over a single year, but over multiple years it has an enormous effect on your wealth.

Pounds versus gold

Another way of seeing the declining value of the pound is to compare it with something else that tends to hold its value far better: gold.

The gold supply can only be increased by pulling more of it out of the ground, and that becomes progressively harder over time as the deposits nearer the surface get used up. As a a result, the total global supply of gold only increases by around 2% per year.

So what happens if rather than measuring prices against something that’s fallen in value over time (the pound) we measure them against something that’s held its value (gold)? The answer: something pretty shocking.

Let’s pick the price of something you’re likely to be particularly interested in as you’re reading this article: UK housing.

Here, the green line shows the average value of a house in the UK as measured by Nationwide, in pounds. Rather than showing the actual price over time, it’s using an “index” – which just means that the price in Year 1 (1952 in this case) is set to 100, and changes in all future years are relative to 100. For example, if the first price is £50,000 and the index is set at 100, then by the time the price has gone up to £55,000 (a 5% increase) the index will show 105.

So looking at the green line, we can see that the index has increased from 100 in 1952 to just over 10,000 by 2020. In other words, house prices as measured in pounds have increased 100-fold. Yikes.

The blue line tracks the performance of exactly the same asset – the average value of a house in the UK as measured by Nationwide – but denominated in gold. In other words, rather than asking “how many pounds does it cost to buy this?”, this is asking the question “how many grams of gold does it cost to buy this?”

What this blue line on the graph shows us is extraordinary. The blue line starts at 100 in 1952, and ends at 100 in 2020. This is telling us that when measured in gold, a house costs the same today as it did in 1952. If you’d been paid your wages in gold rather than pounds during this time period, it would take you the same number of hours of work at the same job to buy you the same amount of house today as it did nearly 70 years ago.

The effects of long-term inflation for property investors

So we’ve demonstrated that long-term inflation is real, learned what causes it, and seen that it has a huge impact over multiple decades even if you barely notice it from one year to the next. But what are its consequences?

This is where things get exciting for investors.

Because for consumers, inflation is neutral at best and highly damaging at worst. If prices go up by 2% per year and so do your wages – and if you’re in the habit of spending everything you earn each month – it doesn’t make any difference. Wait long enough and you’ll be earning £1m per month and paying £10,000 for a loaf of bread, but it doesn’t affect your standard of living.

But what if you don’t spend everything you earn, and want to save some? Unless you can keep your money in a bank account that pays a rate of interest that at least matches inflation, it becomes harder to save up (either for your own future, or for future generations) because the purchasing power of your saved money is always declining.

Yet for property investors, inflation is actually on your side:

1. Property values tend to (at least) keep up with inflation – so the same amount of money invested in property will retain its purchasing power, whereas it would have lost it if you’d left it in the bank.
2. Rents also tend to keep up with inflation, so the real value of your income stream is maintained too.

And when you start using a mortgage, things get even better…

1: You benefit from a “leveraged inflation” gain

Imagine you put down 25% of the price of a £200,000 house as cash, and borrow the rest.
Over the next 10 years, even a low inflation rate of just under 2% sees its value increase to £240,000.

If you sold the house (ignoring taxes and costs), your profit would be £40,000…and you only put down £50,000 in the first place. You’ve almost doubled your money – purely based on the house rising in value along with a low level of inflation.

(Granted, the purchasing power of your £40,000 gain will be less in 10 years’ time than it is today due to that same inflation, but thanks to the leverage you’re still way ahead.)

2: Inflation erodes the value of your debt

Interest-only mortgages make many investors nervous, because the amount they’ve borrowed never seems to fall– so how will they ever pay it back?

Well sure, it doesn’t fall – but it also doesn’t rise. But the value of the property should, thanks to inflation.

So building on our previous example, the £200,000 house is now worth £240,000 but your mortgage is the same £150,000 it was in the first place. As a result, your loan-to-value ratio has fallen from 75% to 62.5% even though you haven’t paid down the debt at all.

Not only that, but although the mortgage amount stays the same in pounds-and-pence terms, the real value of it is always falling – thanks to inflation.

Imagine you’d bought a house in 1980 when the UK’s average property price was £20,268 and you financed it with a loan of £15,000. At the time, that would have seemed like a scary amount to borrow.

Then imagine you just kept paying the interest and rolling the mortgage onwards, so you still owed £15,000 today. Does that feel so scary? No, because that £15,000 has nowhere near the purchasing power it did back then – again, thanks to inflation.

As a result of leveraging the gain and the real value of your debt eroding, over time you end up owing less on an asset that’s worth more – even if you never pay your debt down.

From consumer inflation to asset price inflation

So far, we’ve clearly seen that while inflation punishes consumers and savers, it rewards investors – and particularly rewards investors who use sensible amounts of leverage.

However – so far, in our examples we’ve just talked about the effect on property investors on the assumption that general consumer price inflation (CPI) applied to properties in the same way as it does to goods and services.

But way back at the start of this article, I said that asset prices aren’t included in the CPI figures – so the rate of inflation of assets could be completely different from the general inflation numbers you’ll see reported in the press.

So has asset price inflation been higher or lower than consumer price inflation in the past, and what’s likely to happen in the future?

Let’s look at each in turn.

Asset price inflation: The recent past

Over the last 10 years, total consumer price inflation has been 31% – averaging 2.7% per year. (It sounds like it should average 3.1% per year, but it’s lower due to compounding.)

So if assets had increased in value by the same amount as the average basket of goods, you’d expect them to have gone up by 31% too. But what’s actually happened?

  • The value of the FTSE All-Share has almost doubled
  • House prices are up by 63%
  • Gilts (otherwise known as government bonds) are up by 80%
  • Gold is up by 180%

Why? Two reasons: low interest rates and money-printing.

Between the financial crisis of 2008 and August 2016, the Bank of England created £445bn of new money through a process known as Quantitative Easing (QE).

Much as I’d enjoy spending a couple of thousand words talking about QE in detail, for now only two things matter: why they did it, and how they did it.

First, the why: in the aftermath of the financial crisis, confidence in the economy was weak and the Bank of England was struggling to generate enough inflation to meet their 2% target. Normally, to generate inflation they’d reduce interest rates…but they’d already cut them all the way back to 0.5%, and going further wouldn’t have any effect.

Then, the how: QE involves creating money out of thin air, then using that money to buy assets (mostly government bonds) from banks, pension funds and other institutions. This is highly simplified, but the idea (described in this Bank of England paper from 2009) is that:

  • Those institutions that now had cash in place of their assets would go out and buy more assets – pushing the price up
  • The yield available on government bonds would fall as their price rose, driving people to invest in other asset classes instead (like property and the stock market) – pushing up the price of those assets too

The idea was that as a result of asset prices increasing, economic activity and consumer prices would increase too – through a combination of increased confidence, cheaper borrowing and newly enriched asset holders.

If you’re thinking “hmm, I don’t quite see how that would work”, you’re not missing anything: a House of Lords Select Committee wrote in July 2021 that “the evidence shows quantitative easing has had limited impact on growth and aggregate demand over the last decade.”

(If you’re thinking “this sounds like it would massively increase inequality by enriching those who already own assets without doing much for anyone else”, you’d be right about that too.)

In other words, QE hasn’t been particularly effective at generating consumer price inflation. But it has been spectacularly effective at generating asset price inflation.

Asset price inflation: The future

For investors today, the big question is whether the past decade of asset price growth is going to repeat itself over the next decade. And there are some signs that it will.

Firstly, I mentioned that there had been £445bn of QE between 2008 and 2016. I didn’t mention that there was another £450bn of QE in 2020 alone – yes, doubling the amount in a single year – in a response to Covid-19. Some of that stimulus may be yet to feed its way through to the markets, although the rising house prices of the last year suggests that it’s well underway.

Another reason is that the Bank of England is likely to continue to find it difficult to generate its 2% inflation target over the medium-term (even though at the time of writing it’s high in the short-term), because there are so many deflationary pressures on the economy: technology, an ageing population, and falling energy costs to name just a few.

As a result, whether they indulge in more QE or not, they’re highly likely to keep interest rates as low as they possibly can. And low interest rates are supportive of higher asset prices.

So this is purely my opinion, but it seems likely to me that whatever consumer price inflation we see over the next decade, we’ll see a higher level of asset price inflation. Why? Because the Bank of England will need to take action to generate the amount of price inflation they want – and all the actions they can take will generate asset price inflation too.

Inflation = An investor’s best friend

But for property investors, general inflation can still work some serious magic – even if my prediction about future asset price inflation is wrong.

As I’ve said, even with just a couple of percentage points of inflation per year and no additional asset price inflation, you’ll see the value of your asset keep pace and your rental income stream grow.

And if you invest using a mortgage, then inflation truly becomes your best friend: even a 2% annual gain in house prices can translate into 6-8% growth in the amount you’ve personally invested thanks to leverage – and as I showed in the example earlier, this would mean doubling your money over a decade.

Plus, at the same time, your loan-to-value is dropping and the real value of your mortgage is falling every year.

So for savers and earners, inflation is neutral at best and damaging at worst. For investors though, inflation works for you rather than against you – providing a major tailwind to your investment performance, which is then supercharged through sensible use of leverage.

Although inflation sounds boring, it’s a concept well worth taking the time to understand. Because when you understand it, and what it means for you as an investor, you’ll get excited about it. And once you’re excited about it, you’ll be motivated to harness it to your advantage. And over a period of decades, that advantage could be life-changing.

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