Savers pay a high cost as those who run up debt escape penalties

AS MORE economic news in the UK points to "unexpected" increases in inflation coupled with a Bank of England focus looking to the long term, thoughts turn again to those who have diligently been saving cash.

The Bank of England is in a difficult position: inflation continues to rise and there is a preference for adopting a "wait and see" approach as the position develops in the coming months.

With interest rates at 0.5 per cent, people who have borrowed too much money are in a good position, but with the Retail Prices Index measure of price inflation approaching 4 per cent, there is a significant loss of purchasing power for savers. The significant debt created by the government to "revive" the economy and bail out the banking system has resulted in unconventional measures such as quantitative easing being used in several developed economies to stave off the biggest threat of a prolonged economic contraction since the 1930s. In the UK, QE has largely been used to purchase the debt that the government has issued in the debt markets through gilts.

The long-term implications of QE are a point of vigorous debate, but we firmly believe it will result in inflation. In general terms, if you massively increase the supply of anything, the price reduces. Printing more money causes the value of existing pounds to reduce. This has not happened to a great extent yet, due to the hoarding of cash by banks to plug black holes, although the effects of it have been felt in the surprising resilience of real asset values, such as house prices.

In the UK we have become accustomed to importing a large number of the goods that we consume and, therefore, the impact of currency weakness serves to increase the price of goods. Advocates of deflation point to the output gap and argue that if we are operating below the potential level of output, then there will be fierce downward pricing pressure due to the excess capacity of producers of goods and services.

We don't believe that this is a cogent argument in the UK because of the dependence on services. About 80 per cent of peak overall output is accounted for by services and, of that, nearly half is in business and financial services. A large portion of the so-called excess capacity has actually been destroyed by the credit crunch and the argument does not hold as a result.

The most important point relates to the outlook for the UK in terms of issuing more debt. The Bank recently announced that it would stop QE. Nearly 200 billion of QE was used to purchase gilts this year and the current annual gilt issuance is running at more than six times the norm over the ten years prior to the credit crunch. It would be too risky to flood the market with this kind of issuance and risk a buyers' strike.

The Bank will simply have to undertake further QE or force the high street banks to purchase gilts. Either way, this is bad for the economy.

Undertaking further QE at a time when no other major economy is doing so will cause the currency to depreciate and provoke further inflation. Forcing the banks to purchase gilts will halt a recovery in the economy as there will be even less cash available at commercial rates to the consumer or companies. This is likely to manifest itself in a fall in the GDP output figures and lead to further weakening of sterling, again forcing up inflation.

There is no obvious answer given the complex state of affairs. It seems highly unjust that the odds are stacked so heavily in favour of those who borrow excessive levels of debt and from whose actions much of the trouble has stemmed. This is the moral hazard of the situation.

Whatever the case, it is a real problem for savers who hold cash and who should be worrying about how to protect their hard-earned nest eggs against the threat of rising inflation.

• Haig Bathgate is investment director at Turcan Connell