One of the great unanswered questions in the markets right now is whether inflation will return to previous levels – and, amid greater controls and alternative investment opportunities to work around its impact, whether inflation even matters any more
The world has got used to low inflation. In the past 25 years, inflation has been incredibly low compared with prior decades, and not just in economies that have struggled, such as Japan, but also in economies that have experienced episodes of high growth.
The fact is that for many, it has become the norm – ‘just the way it is’. But is that attitude complacent?
As ESSEC Business School professors Radu Vranceanu and Marc Guyot point out in their paper Why the return of high inflation can no longer be excluded: “The US inflation rate exceeded 4% only briefly in 2005 and in the wake of the global financial crisis of 2008. And, since the creation of the European Monetary Union (EMU) in 1999, the [European Union] inflation rate exceeded 4% only for a few months in 2008.”
Inflation sceptics point out that inflation has been low despite central banks engaging in massive asset-purchase programmes that multiplied their balance sheets by a factor of four.
But, as Vranceanu and Guyot argue, these sceptics attach less emphasis to the fact that the monetary base did not increase much, with many commercial banks holding huge amounts of reserves with the central banks.
Rise of the sleeping giant?
Some economists predict inflation’s return with considerable confidence, citing the amount of cash that has been printed by central banks, such as the Federal Reserve.
In the US, Harvard economist Lawrence Summers has asserted that adding President Joe Biden’s $1.9trn stimulus package to the $3.1trn deficit that the Trump administration ran up in 2020 has the potential to revive inflation “of a kind we have not seen in a generation”.
In the eurozone, meanwhile, Philip Lane, Chief Economist at the European Central Bank, has said that the bank is “closely monitoring” bond yields.
In early March, the Australian Central Bank decided to steer its bond purchase programme to unravel the increase in long-term yields. Continued support to the bond market is the wrong signal to send if the original selling movement in bonds is determined by raising inflation expectations.
Vranceanu and Guyot suggest that, with a supply shock on the one hand, and governments engaged in massive spending plans – and central banks ready to support them by monetising debts – on the other, there is little left to keep inflation expectations under control.
Contrasting views
While many economists have underplayed both the threat and impact of inflation, since the beginning of the year some investment fund managers have been actively hedging against inflation.
In his annual letter to investors, delivered at the end of February, Warren Buffet recommended avoiding the bond market, where rising inflation fear could entail big losses.
As Vranceanu and Guyot point out, his predictions were correct in 2001 and 2008 – so what’s to say he is not correct now?
These fears of out-of-control inflation are in contrast with the views of US economist Joseph Stiglitz, Professor at Columbia University, who in February this year referred to inflation as a “bogeyman that is more fantasy than real threat nowadays”.
Stiglitz argues that if inflation rises, the Federal Reserve will simply increase the short-term interest rate, as it did in the past. Furthermore, as echoed by advocates of modern monetary theory (MMT), should inflation return, the government can simply increase taxes on those with higher incomes.
So, given all the contrasting views and divided opinions, can anyone accurately predict which is the most likely outcome on inflation?
It depends what timeframe you are talking about, argues James Cooke, Head of Global Equity at Jersey-based Ashburton Investments.
“In the short term, we can predict where inflation will be – that it will peak at 3% and then lower for the second part of this year. But the longer term is far harder to predict and largely depends on how central banks interpret stable pricing.”
The problem with only being able to accurately predict short-term inflation scenarios is that most investors are advised to invest for the long term – typically five to 10 years or more.
As Cooke points out, if you are invested in a 10-year gilt offering 0.75%, you are locking into losses if inflation is rising.
Does inflation really matter?
In a world where millennials and other emerging investor groups and wealth holders are increasingly the decision-makers – and increasingly driven by other motivations – does inflation really enter the equation as it once did? Are we getting too hung up over the issue?
Cooke concedes that the pandemic has meant people have not been spending to the same degree as normal and are now looking to invest this surplus cash.
Alternative options are catching the eye – notably speculative vehicles such as commodities (gold), REITs and cryptocurrencies. These investments are not at the mercy of rising inflation.
However, he does not subscribe to the argument that inflation doesn’t matter any more. “If – and it is a big if – inflation were stubbornly high, then interest rates would rise significantly, and this would have huge ramifications for investments.
“Inflation erodes purchasing power over time – essentially it is the reverse of compound interest. It has huge implications for asset classes, with fixed income hit particularly hard,” he says.
Cooke also concedes that, with equities, there is the greater opportunity to shield from the impact of inflation. “The benefit of equities is that they can adjust their pricing in an inflationary or deflationary environment,” he says.
Fund managers are also able to reposition equity portfolios to sectors that are more resistant to inflation.
Cooke explains: “As an equity fund manager, you have to ask what you want to own in a super-inflationary environment. You want to be in companies that produce goods and services that people want and need – sectors such as consumer staples and healthcare.”
He adds that as and when inflation subsides, the shift in preference is for consumer discretionary stocks.
Deflationary factors
When the views of eminent economists on inflation contrast so sharply, it makes it even harder to make investment calls.
It is true that 35% of all US dollars ever printed were produced in 2020. On the face of it, this is alarming, but at the same time, advances in IT have had a deflationary effect. Technology reduces the number of people needed to create a product or provide a service and this, in turn, reduces costs.
And we know that the Covid-19 pandemic has massively boosted adoption of technology. According to a McKinsey Global Survey of xecutives, carried out in October 2020, companies have accelerated the digitalisation of their customer and supply-chain interactions, and of their internal operations, by three to four years.
So can we really make an assumption on inflation and its impact when the landscape has changed so massively? Are the actions of governments – notably the new age of ‘Bidenomics’ – largely dismissive of inflation?
Adam Tooze, an English economic historian at Columbia University, writing in The New Statesman, suggests there has been a “fundamental revaluation of the risk of too much spending leading to the economy overheating and inflation”.
Tooze also notes that there is a realisation that “the greatest threat to liberal democracy in the US is not macroeconomic instability, but social polarisation and Republican politics”.
Perhaps inflation is not the dark spectre it once was – that there is greater flexibility to control it when necessary and more investment options available to avoid its impact.
Former US President Ronald Reagan once compared inflation to a “violent mugger”. Whether it really has lost its menace in the years since then is yet to become apparent.