Is inflation inevitable?
Apart from a couple of oil-related spikes, you have to go back 30 years to find inflation consistently above 5pc. Since the early 1990s, consumer prices have risen less than 2-3pc a year most of the time. For the last ten years, much less.
This matters to investors for two reasons. First, it takes the pressure off. The rule of 72 tells us that a 6pc inflation rate halves the purchasing power of our money in just 12 years. When prices are rising that quickly, your investments have to work hard just to keep their head above water in real terms let alone make you feel any wealthier. At 2pc, that same slide into relative poverty will take 36 years, long enough to see most of us through our retirement.
Inflation is important to investors for another reason. It affects different assets in different ways, with those offering a fixed nominal return, like bonds, particularly vulnerable to rising prices. With asset allocation accounting for as much as 90pc of the long-term performance of our investments, knowing in advance whether inflation is on the way back is key. Of course, no-one has that crystal ball, so all we can do is weigh up the odds.
Credit Suisse has listed five reasons to think inflation could soon be rising again. The first relates to government and central bank policy, which has shifted in an inflationary direction since the financial crisis and, more particularly, during the Covid pandemic.
When it comes to fiscal, or tax, policy, there is no longer any appetite for austerity. Voters don’t want it, which means governments have no reason to impose it, and their crowd-pleasing has the support of the world’s financial watchdogs. In a reversal of the post-crisis orthodoxy, the message from the IMF and World Bank is: borrow cheaply; build back better; and let the future take care of itself.
Interest rate, or monetary, policy is marching to the same drumbeat. The Federal Reserve has tacitly accepted permanently higher prices by adopting average-inflation targeting. Its chairman, Jay Powell, says ‘the danger of doing too much is much less than the danger of doing too little’. Despite forecasting an inflation rate of 2pc and unemployment at 4pc in 2023, the US central bank expects interest rates to remain close to zero until then.
The second driver of inflation is money supply. Print enough money and the excess liquidity will in time leak into higher prices. There is a lag, but with one notable exception it has always done so, as long as the extra money is not squirrelled away in precautionary savings. With household savings at levels we haven’t seen in more than 40 years, money is likely to start flowing again. Last week’s retail sales data here in the UK suggest it has already started.
The exception, by the way, is Japan. But we shouldn’t get too hung up on that comparison. An 80pc slide in asset prices (housing and shares) during the early 1990s, falling wages thanks to rigid labour laws, and insolvent banks ensured that Japan, as in most things, was and remains different.
The third factor is the ending or reversal of many of the disinflationary forces that have characterised the past 30 years. Globalisation is in retreat, and the offshoring of jobs to China and elsewhere is no more likely under Joe Biden than Donald Trump. Oil may have long-term structural challenges as the fight against climate change intensifies, but the price has probably bottomed out. And the lion’s share of the impact of technological changes on the price of goods and services has already been felt - more than a quarter of retail sales in the UK are now online, for example.
The fourth driver of future inflation is demographic. The proportion of people born after 1980 will shortly be greater than those born before that date. These millennials are justified in thinking they have drawn the short straw in the lottery of life. They are saddled with student debts, millstone mortgages and stagnant earnings. Most of their problems would be at least alleviated by letting inflation reduce the real burden of their debts. As this generation becomes more influential in the electoral arithmetic, we should expect government policy to favour them more than their pampered parents. In the US, eight states have already moved to legislate a US$15 minimum wage.
The final driver of future inflation is the most powerful. There are only three things a government can do to reduce the kind of debts they have racked up, not just because of the pandemic but after years of spending more than they can collect in tax. They can default, impose austerity or inflate the debts away. Default is inconceivable in a developed country with the ability to print its own currency; austerity is politically unacceptable to the extent that would make a difference, and on this scale it would also be self-defeating; which leaves only one option - inflation is, therefore, inevitable.
The good news for investors is that it will not happen overnight. There is time to prepare and the remedies are easily identifiable, albeit there are fewer solutions than was the case last time rising prices were a problem. That’s because two of the four classic real asset inflation hedges - oil and property - have their own deep-seated problems.
The third and fourth havens, however, continue to provide a port in the expected inflationary storm. Shares have historically performed well when inflation is contained below about 4pc and only above 6pc or so have they been significantly blown off course. Gold, which has lost its lustre of late as investors assume that a vaccine solves everything, still has a place in any portfolio. Credit Suisse just hoisted a US$2,500 an ounce price target above the yellow metal.