“Inflation is always and everywhere a monetary phenomenon.”
Milton Friedman, 1970
After many years of low interest rates and low inflation, financial markets have recently started to become worried that we may face a period of higher inflation in the years ahead. In this article, we explore the reasons why inflation is suddenly such a hot topic of conversation in markets, and what a period of higher inflation may mean for investors.
American economist, Milton Friedman, is considered by many to be the father of monetarist economics. This theory, which became popular in the 1970s and increasingly shaped economic policy in the US and UK from the 1980s, suggests that interest rates (monetary policy) should be used as the primary tool for controlling economic variables such as inflation and unemployment, rather than ‘Keynesian’ fiscal policy (changes in the level of government spending). By changing the rate of interest at which lenders can lend and borrowers can access credit, the theory suggests policymakers could influence the amount of money circulating in the economy. High interest rates would reduce the demand for credit, and therefore stem inflationary pressures and allow an economy to cool down, while low rates of interest could be deployed when more demand needed to be stimulated in an effort to accelerate economic activity.
Hence, the quote above from Friedman, reflects a belief that the rate of inflation in an economy is always linked to the amount of money circulating in that economy. Indeed, taking this one step further, Friedman is arguing that the main driver of inflation is the rate at which the supply of money is growing.
To an extent, history provides strong evidence to support this theory. After all, the infamous periods of runaway inflation that blighted Germany almost one hundred years ago and Zimbabwe at the start of the 21st century, were triggered by rampant money printing to escape economic adversity.
And herein lies the root of the market’s current concern about inflation. Western governments appear to be set on a similar course to the one that has caused major inflationary outbreaks in the past, creating money (in this instance, electronically via quantitative easing – QE – rather than by cranking up the printing press) in a bid to support our economies through a period of pandemic-related uncertainty and suppressed demand.
Should we expect the same inflationary outcome this time? Is the market right to be worried about a period of higher inflation? Our answer to these questions is, perhaps.
The same – but different
It is true that we – that is the economies of Europe and North America – are embarking upon a period of unprecedented growth in the supply of money, as a result of the policy response to the global pandemic. But money supply has been growing rapidly through QE for years now. The policy of QE was introduced in the UK and US in the financial crisis in an extreme and experimental attempt to stave off an economic depression, the likes of which the world had not seen since the 1930s. It was divisive among economists at the time, and it remains controversial to this day, because nobody knows what the ultimate consequences of all this electronic money printing will be. Supporters of Friedman’s monetarist theories have been fearing the imminent arrival of inflation ever since QE was first introduced, whereas many other economists have remained more fearful of deflation (falling prices).
Nevertheless, QE has thus far persisted without creating inflation. The main reason for this is tied to the reason it was introduced in the first place – to avoid a deflationary economic depression. In this way, QE can be viewed as a success. As the chart below illustrates, we have endured very low levels of inflation for the last decade but have avoided outright deflation.
Inflation hasn’t been a major problem in the UK since the early 1980s
What’s different now is that the scale of money printing was increased dramatically during the pandemic. For example, 21% of all US dollars in circulation were printed in 2020. Historically, and even during the ten years of QE prior to this, that number has rarely been above 5%. Plus, we also have an enormous amount of fiscal stimulus as well as monetary stimulus. Governments stepped in in a major way during the first wave of the pandemic – offering support to workers that lost their jobs (either temporarily or permanently) and to businesses that were struggling due to the absence of demand for their products and services during lockdown. This stimulus remains in place, albeit at a lower level, and the government deficit (the gap between the level of a government’s spending and its receipts through taxation) and the national debt burden, are at record levels outside of war time.
Meanwhile, as we emerge from lockdown, we are beginning to see the impact of pent-up demand being unleashed. Economic activity is now picking up strongly, and the UK is expected to see its strongest year of growth since the late 1940s.
These conditions have provided further fuel for the monetarist’s inflationary arguments, and even some of the die-hard deflationists are now becoming more concerned about the inflationary outlook.
The old enemy
The risk is, however, that policymakers are out of practice in the fight against inflation. As the chart above demonstrates, it is so long since inflation was a major problem in this economy that you could argue that the current generation of central bankers is too young to remember how to combat it. Our policymakers may not remember how painful a period of persistently high inflation, such as the one that the UK endured in the 1970s and 1980s, can be.
Indeed, many policymakers talk about the benefits of a period of higher inflation, as a means to reduce the debt burden. The price of goods and services may rise, but the value of debt does not. Gradually, over time, a debt problem can therefore be diminished by inflation, albeit the economic price is paid in other ways.
So, there are reasons to believe that we may see a period of complacency from policymakers, during which higher inflation is tolerated. In the UK and the US, we currently see inflation rates in excess of the 2% level that is targeted by policymakers and the Federal Reserve, which is responsible for American monetary policy, has already moved to “average inflation targeting” which will allow it to endure higher levels of inflation for a period without raising interest rates immediately. It seems likely that “The Fed”, as it is commonly known, will announce a plan for reducing the pace of its QE programme later this year in response to rising inflation concerns, but the prospect of interest rate hikes still remains somewhat distant.
One thing we do know from history is that, once the inflation genie is out of the lamp, it is very difficult to get it back in.
The counter argument
Of course, there are also many reasons to believe that inflation will remain well contained, even if we do see a temporary pickup in price rises as economies continue to attempt to normalise in the months ahead. Many economists continue to argue that the deflationary factors that have helped to keep the lid on inflation for so long remain firmly in place. Deteriorating demographics in the western world, for example, are deemed to be deflationary. Population growth has slowed in many nations and ageing populations tend to mean that a smaller workforce supports a higher proportion of retirees. This has contributed to Japan’s deflationary conditions over the last thirty years, and many other western economies are on a similar path.
Meanwhile, technology is seen as a deflationary force, with the price of many goods and services becoming steadily cheaper as a result of disruption and digitalisation. And the debt burden with which many western economies are now saddled, is also likely to act as a hindrance to economic growth and price rises. The theory of “debt deflation” was first developed during the Great Depression of the 1930s, to explain how high level of debt in an economy can ultimately cause falling prices, rising unemployment and a contraction in economic activity. This theory became important again during the Global Financial Crisis of 2007-09 and, although the policy response to that event was very different to the way the Great Depression was handled, concern about the threat of sustained deflation will likely linger for as long as our economies are weighed down by high levels of debt.
So, all things considered, the return of inflation should not be seen as inevitable, but the inflation vs deflation debate does appear to be more finely poised than it has for some time.
What might higher inflation mean for investors?
For more than a decade now, financial markets have become accustomed to low inflation and low interest rates. This has gradually filtered through to the way different parts of the market have performed, and to the prices at which certain assets have been changing hands. If we move from a low inflation backdrop to a higher inflation one, many of the trends that have been in place in markets for the last decade may well go into reverse. We must be prepared for a potentially very different market environment going forward.
Your investment committee has been actively looking at what types of asset perform well during periods of higher inflation. Some assets, such as real estate, are known to perform well in such conditions. These are known as “real assets” because the price of property (in particular, commercial property) tends to broadly keep pace with, or even exceed, the rate of inflation over time. We have been researching the available options for introducing some global commercial real estate exposure to your portfolio and will soon be making a recommendation to slightly alter the shape of the portfolio to include some exposure to global commercial property (not residential property) for the first time.
Equities are real assets too and have preserved their value reasonably well in past periods of inflation. If the dynamic within markets changes, however, we should perhaps expect a different sort of stock to lead returns going forward. Your diversified portfolio strategy is well-placed in this context.
Finally, bond investments may be seen as more vulnerable to a period of higher inflation, particularly if interest rates need to rise to control it. But here too, your investment strategy is sensible. We are focused on “short duration” bond assets – those that do not have long until they mature. Long duration assets tend to be much more volatile and look much more exposed to a period of higher inflation and interest rates, than do the short duration assets that are held within your portfolio.
We may be facing a period of higher inflation. Certainly, the probability of such an eventuality has risen over the last eighteen months. We must hope that our central bankers and other policymakers know what they are doing and can remember what they need to do to control inflation if it arrives.
From the perspective of a long-term investment strategy, inflation is not something to fear unduly. Your portfolio is carefully constructed and there are some things we can do to alter its composition if it becomes appropriate, to help safeguard your assets and to take advantage of opportunities as they arise.
The outlook for inflation is one of the many factors that your investment committee monitors carefully and discusses regularly. The outlook for inflation is one of the many factors that your investment committee monitors carefully and discusses regularly. We will recommend changes to portfolios should it become appropriate.