The great wealth reducer - It’s the beast of economics; it breathes fire on investors’ carefully constructed portfolios.
We refer to inflation.
We keep hearing it’s down to one-offs, but inflation has remained stubbornly over target. The Bank of England says if you ignore food and energy and the effect of the low pound and the recent rise in VAT, then inflation is not so bad. But then again, how many things must you ignore to draw this positive conclusion? You could say of a team that lost a football match, if you ignore the goals it conceded it would have won. Inflation can make low risk investing risky. After all, if you want to protect your portfolio from being eroded by the ravages of inflation, investing in bonds (which are currently paying out yields that are lower in percentage terms than inflation) is quite a risky thing to do. So this begs the question, is inflation really going to fall? Or will it shoot up?
The Bank of England’s Monetary Policy Committee (MPC), which is charged with the task of setting interest rates, must surely resemble a dovecote at the moment. For we are constantly being told it has lots of doves. Current chief dove is Adam Posen. For the last eleven meetings of the MPC he has voted for the Bank of England to go out and create new money via that monetary vehicle called quantitative easing (QE).
The MPC recently lost its arch hawk Andrew Sentance. He voted for rate hikes over and over again, but his tenure is now up. And now he has gone, even those MPC members who occasionally joined him in voting for a rate hike have gone quite dove–like, and in the most recent meeting not a single vote was cast in favour of an interest rate hike. It seems rates are likely to stay where they are for a good while yet. Many say more QE may yet be on the cards. In the US, Fed Chairman Ben Bernanke recently hinted that US rates are set to stay at their record low right through to 2013.
But what inflation do we need to worry about?
These days headline writers covering inflation concern themselves with what is called Consumer Price Index (CPI), which the Bank of England is supposed to keep at around 2%. If inflation moves more than one full percentage point above or below this target, the bank’s Governor, Mervyn King, has to get his letter writing book out and rattle off a letter to the Chancellor explaining himself. He must be suffering from writer’s cramp, because he has been writing a lot of letters lately. CPI inflation has been over 3% every month since March 2010. In September it was running at 5.2%.
But there are other measures that matter too. There’s the old fashioned Retail Price Index (RPI), which differs from the CPI partly because it includes mortgage payments and council tax. Many prefer it. Some say the shift from RPI to CPI was a con, designed to fool us into thinking inflation was lower than it actually is. More to the point, many wage settlements are based on the RPI measure. There’s also core inflation, which excludes food, energy and tobacco. In the year to August this was 3.1%. Then there’s CPIY – CPI inflation minus the effect of indirect taxes such as VAT. In the year to September this was 3.7%. But commodity prices don’t always go up. If global economic conditions worsen, food and oil may fall in price, pushing down inflation. Furthermore, VAT went up in January. By the beginning of 2012, the effect of the VAT rise will have worked its way out of the annual figures, and CPI inflation should be much lower, and more or less aligned with the CPIY rate.
Then there’s the cheap pound. This is having an inflationary effect, but sterling has not changed that much relative to the euro and dollar in recent months. Assuming this stability continues, one would expect import led inflation to fall too.
QE
And that brings us to those two dreaded words: quantitative easing or QE. There many who believe the inevitable consequence of QE is inflation. But don’t be so sure.
It is important to understand why we have had QE. It boils down to your view of what causes severe recessions. Why was the depression of the 1930s in the US so awful, that we call it the Great Depression? Milton Friedman, the man who pretty much invented what we call monetarism, said that it was largely caused by a series of banks going out of business, which in turn led to a sharp contraction in the money supply. He said that if we should ever face similar circumstances again, then, if all else fails, we could always kick the economy back into life by dropping money from a helicopter and scattering it across the land. Sometime later, an obscure academic, who specialised in the causes of the Great Depression, made a speech in which he repeated the helicopter drop option. That academic was called Ben Bernanke, and he now heads the Fed and is the most powerful central banker in the world.
It is important to understand why we have had QE. It boils down to your view of what causes severe recessions. Why was the depression of the 1930s in the US so awful, that we call it the Great Depression? Milton Friedman, the man who pretty much invented what we call monetarism, said that it was largely caused by a series of banks going out of business, which in turn led to a sharp contraction in the money supply. He said that if we should ever face similar circumstances again, then, if all else fails, we could always kick the economy back into life by dropping money from a helicopter and scattering it across the land. Sometime later, an obscure academic, who specialised in the causes of the Great Depression, made a speech in which he repeated the helicopter drop option. That academic was called Ben Bernanke, and he now heads the Fed and is the most powerful central banker in the world.
Those who think QE is guaranteed to create inflation are forgetting a key point. Money is complicated and banks can create it. If you borrow money from your bank you may spend it, meaning someone else will pay the money you borrowed into their bank account. Their bank may, in turn, lend this money out. In this way, the money supply grows. And right now, banks don’t want to lend. We are seeing no obvious rise in what economists call broad money.
Regulators want banks to have higher capital to lending ratios. This will surely mean even less lending. So does that really mean QE is doing nothing?
Not entirely. Who is to say what would have happened without it. For all we know QE may have stopped the rout of capitalism in its tracks. QE is also pulling down the yield on US and UK bonds. Equities seem cheap, so they rise. Maybe other assets, such as oil, also rise for the same reason. QE has also led to a cheaper dollar and pound, so inasmuch as US and UK inflation had been created by higher import prices, you could say QE has been mildly inflationary.
The Yuan
Some US politicians are spitting feathers. They hate the way China maintains a cheap currency valued in dollars. In order to keep its currency – the yuan or renminbi – down, China has to buy dollars, which entails buying US assets. During the boom years, Chinese money flooded into the US, which helped to keep interest rates low. Now things are changing. China is trying to move up the value chain, and compete more on quality, less on price.
Be careful what you wish for. If China does do this, it may help US exporters, but the inflationary effect will be very serious.
Deleverage
Before the story of inflation is complete, there is one other important factor. During the last decade consumers built up massive debts, which funded some of their spending. Stagnant or falling house prices means consumers are now reluctant to carry on borrowing. At the same time, the baby boomer generation is focusing on retirement. The result: saving rises. Irrespective of how much money banks are willing to lend, consumers don’t want to borrow as much as they used to. QE means central banks are doing what the economist Keynes called pushing on string. They are trying to create a recovery based on borrowing, when indebted households don’t want to borrow.
How will it pan out?
Right now, it appears that growing global demand, created by the emerging countries, is pushing up energy and food costs, leading to worldwide inflationary pressures. In the UK, this year’s rise in VAT and the cheap pound has added to this effect. But US and UK consumers are reluctant to spend, which is pushing down prices. And so we see two contradictory forces at work – one pushing up, the other pulling down. However, if the global economy does indeed see a sharp slowdown, this may lead to lower oil and energy prices, meaning that, if anything, prices are more likely to fall than rise.
In the longer term, the rise of China, the increased demand for investment from other emerging countries, the gradual appreciation of the Yuan, and the final retirement of the baby boomers, may mean things will go into reverse. Demand may exceed productive capacity, and both inflation and interest rates will be pushed upwards. More to the point, real interest rates – that is to say interest minus inflation – may rise too. If this proves right, opportunities will be there for all, but those who are heavily indebted may find conditions become too tough to handle.
Diversification...
... otherwise know as asset allocation. Whilst some asset types are more prone to being adversely affected by the ravages of inflation (such as cash deposits), others are potentially inflation protectors i.e. shares, commodities, property funds, ‘index linked gilts’ and NS&I index linked certificates (when available).
Within share funds, the investment manager can hold infrastructure companies – where long-term contracts have their costs and income linked to the Retail Price Index. Also, defensive stocks such as utility companies and pharmaceuticals usually transfer their higher costs onto consumers – so the customer pays, not the owners of the company. In summary, therefore, strategies can still be adopted to defend your wealth against inflation and potentially protect the buying power of your money.