I was asked the other day for whether inflation is on the horizon as a response to global central banks’ efforts to limit the effects of COVID 19. Here are my views:
Yes, it is possible that there is an increase in inflation as a result of stimulus packages issued by global governments but this was also a prediction post the Credit Crunch and, other than a couple of years where it picked up above 3% (4.8% in 2010 and 2011 and 3.1% 2012*), it has largely remained benign.
This is in large part due to suppressed wage growth during austerity and technological developments making goods cheaper to produce. There is good reason to believe these influences will continue (Austerity II?). Quantitative Easing did not have the inflationary effect that many predicted because central banks bought their own debt and so moved money around the economy creating liquidity rather than new money (which does tend to lead to hyper-inflation as experienced in post-World War I Germany, Zimbabwe and Venezuela etc).
Where Will it Come From?
Many people are expecting governments to increase taxes to repair the gaping holes in their budgets. If this is to happen the working population would have less discretionary spending power and therefore be non-inflationary, possibly even deflationary.
If taxes are to be increased there could be some easy tax wins; only the very rich bemoan increases to the top rate of tax but it can also be counter-productive. Known in economic circles as the Laffer Curve, the total tax take reduces if there are disincentives to earn money or loopholes are found to reduce tax liabilities. It is also not a strategy to win or retain power if the voting population feels hard done by.
That said, of course, anything is possible, and inflation might increase significantly, it can be used as a strategy to inflate the debt problem away. By targetting higher inflation governments and Central Banks can reduce the real-term value of debt over time making it cheaper to pay it back.
It may not be created internationally or come through government responses but be imported as a result of other means: geo-political tensions (Trump’s trade wars and/or the cost of oil supply) or through corporate actions resulting in consumers not necessarily paying more but getting less, have you noticed how small chocolate bars are these days? (that’s what food manufacturers call ‘shrinkflation’).
What To Do About It?
If inflation does pick up your cash would lose value in real terms. Real assets (shares and property) are the best way to counter inflation and so between pensions, investment portfolios and properties investors are protected.
Lower risk assets such as government bonds (other than inflation-linked bonds) lose value when inflation and/or interest rates increase but the role they should be playing in portfolios is to reduce volatility. If portfolios are established appropriately and in line with long-term objectives I don’t believe there is a need to increase equity exposure any further just to counter possible inflation spikes,
Inflation-linked bonds and longer-dated bonds tend to be more volatile than short-dated, investment-grade bonds so investing in them as an inflation hedge might just create greater swings in value. Conversely, when investing in short-dated bonds (terms of 5 years or less), new issues will likely provide higher yields to reflect increases in inflation and interest rates.
Gold is often viewed as the best way to hedge against inflation and it usually serves as a ‘go-to’ asset when there are fear and uncertainty in the markets. However, it does not provide an income in the way that shares, bonds and rental property does and, being a speculative trade, is also be volatile**.
As with investing generally, the most appropriate strategy is one of diversification, not taking speculative punts and maintaining patience and discipline in the face of uncertainty.
*Source: EBI Portfolios Ltd Matrix Book
** Source: https://www.longtermtrends.net/stocks-vs-gold-comparison/
