How seriously should investors take inflation?

Inflation has been on the rise recently in the UK and around the world. Is this rise transitory, as central bankers are saying it is, or persistent and therefore cause for concern? 

The importance of this question cannot be understated.  

The high inflation of the ’60s and ’70s did huge damage to economies and financial markets – as did, for a while, the high interest rates in the early ’80s that were needed to stamp it out. ‘Balanced funds’ (those investing in bonds and equities in similar proportions) performed far worse in real terms through that period than they did during the depression of the 1930s. (By way of example, inflation hit 9% in 1990 and an average ‘balanced fund’ fell by 6%.) The reason for this was that although the deflation of the ’30s was bad for equities, it was great for real returns from government bonds.  

The role of central banks in inflation

The stated aim for central banks is to maintain stable prices and achieve full employment. However, these are not mutually exclusive. There may be circumstances in which a level of employment that is deemed low full can cause inflation to rise.  

Take the present circumstances, for example. Labour markets are tight – causing wage pressures to increase – because Covid-19-related enforced saving has led some people to feel they do not need to work. The role of inflation expectations is critical.  

Once there is a belief that above-target inflation is here to stay – in other words it’s non-transitory – positive feedback loops, known in the trade as ‘multiple expectations-based dynamic feedback loops’, can drive it relentlessly higher. Furthermore, anchored inflation expectations rely on a widespread belief that central banks will do whatever it takes to stop inflation expectations rising too much. For the US Federal Reserve to say that it will tolerate above-target inflation for an unspecified amount of time - but also that the recent high and rising inflation is transitory - appears contradictory and risks damaging its most important asset: its credibility.  

The projected UK position

At the same time, there is good reason to believe that the current high inflation – in the UK it would now be closer to 4% without the ongoing VAT cut from 20% to 5% for some goods and services – will indeed be transitory.  

The structural forces that are deemed by many economists to have driven down the natural rate of interest (and with it inflation) over the past 40 years such as ageing populations, high wealth inequality and low labour intensity still prevail. Once the current drivers of high inflation, namely base effects and artificially high saving rates are behind us, these forces may re-engage. 

What does this mean for interest rates?

UK interest rates could rise in the next year, if the recovery continues and rising prices lead to ‘more persistent’ inflationary pressures.  

 Michael Saunders, a member of the Bank’s Monetary Policy Committee which sets rates, told an online session in early September that the economic outlook would determine when interest rates will rise from their current record low of 0.1%.  

Conditions required for an interest rate rise

Saunders explained that if the economy continues to recover, and inflation shows signs of being more persistent, then it might be right to think of interest rates going up in the next year or so. Saunders also predicted that any rise in interest rates in the next year or so should be ”relatively limited”, given that the “neutral” level of interest is much lower than it used to be (the neutral level of interest is the point where rates are neither stimulating the economy nor restricting growth).  

Inflation dropped back to the Bank’s 2% target in July 2021 but is expected to surge to around 4% by the end of this year.