Last week, inflation this side of the pond hit 3.8%, almost twice the target rate of 2%. What does this mean for investing?

I was at an excellent series of presentations by Citi bank last week and one of the statistics they demonstrated was that when inflation goes above the 3-4% range, stock markets fall significantly across the world. What drives this relationship?

The prevailing theory explaining inflation at the moment is monetarism (as opposed to Keynesian theories). Basically this says that inflation is caused by too much money chasing too few goods. The prices of goods are effectively being auctioned up.

With most things, if you want to cut the demand, you make it more expensive. The demand for money is dictated by the price of money which are interest rates. When interest rates are low, consumers will be tempted to borrow (thus increasing their demand for money).

The Bank of England will therefore have to either adopt higher interest rates or maintain them where they are at the moment. And although interest rates are historically low, they are very high in terms of our recent experience over the last 10 years.

Interest rates also represent the risk-free rate of holding money. If interest rates are high, investors may decide that they would rather invest their money in deposit accounts than risk the money on stocks and shares or unlisted companies. If interest rates are high, they will need a much higher rate of return from other potential investments.

You can observe this relationship in the real world. When interest rates go up, the stock market tends to go down and vice versa. Sadly therefore, as entrepreneurs looking for investments you do need to realize you are in competition for the investor’s money with not only other businesses - but also with other potential investments they could make in other assets.

The point is you should be aware of the investors mind set and price your business accordingly.

Please don’t do the “you will get 10 times your money back within three years” unless you have some evidence to back it up!

Best of luck.

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