26 Jun Inflation or deflation?
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Inflation (the rate at which the prices of goods and services increase) is a stealthy thief of the value of investors’ capital. From time to time, it hits the headlines when rates get out of control (for example, in Germany during the period of the Weimar Republic, Zimbabwe in the first decade of the 21st century or, less well known, Hungary in 1946).
Fortunately, such episodes are newsworthy precisely because they are uncommon but over prolonged periods, even a low rate can have a significant impact on the purchasing power of money. For example, even at an annual rate of only 2%, the spending power of £1 is reduced by a third over 20 years and by half after 35 years. Such time horizons are certainly not inconsistent with the typical time horizon of a typical investor at the time they stop paid work. To add some context, a man aged 60 today can expect to live a further 25 years and a woman of the same age two years beyond that.
Anyone faced with the prospect of living either wholly or partially on their financial capital therefore needs to be aware of the potential impact of inflation and to incorporate into their planning a strategy for how to mitigate its impact on their future lifestyle goals.
With the UK government having adopted an approach to the Covid-19 crisis which involves significant increased public expenditure, there are naturally concerns being expressed in economic circles as to the long term impact of this. Having experienced a period of sustained low inflation over the last few decades (the annual increase in the Consumer Price Index last exceeded 5% in 1991 and for most of that time has been under 3%), UK-based investors have become used to inflation seemingly being under control. Yet those who have been around for a few years will remember how UK inflation (then measured by the Retail Prices Index) spent most of the 1973-81 period in double figures and hit over 24% in 1975. Unsurprisingly, those who do recall those times might well look forward with some nervousness to the question of whether we might be due a repetition of that.
As noted above, hyperinflation, which is relatively rare, particularly in developed economies, is where prices increase rapidly, typically by more than 50% in a month. It tends to arise when there is a loss of confidence in the country’s currency and the ability of the central bank to maintain its value. In such circumstances, people start to hoard non-perishable goods and anything which they perceive might retain its value, which causes basic commodities such as food and fuel to become scarce and thus more expensive.
Fortunately, despite the undoubted impact of recent events, there seems to be no obvious risk of the UK suffering hyperinflation any time soon.
Yet the measures that governments took after the 2007-09 global financial crisis (cutting interest rates and injecting money into the economy) did create inflation, even if in asset prices rather than in goods and services. The potential problem is that this was funded by cheap debt and at some point, a debt-fuelled bubble will burst. Since the only way that most governments dare to default on their debts is to inflate them away, there is an argument that high inflation is more likely.
Deflation, unsurprisingly, is a measure of a general decline of the prices of goods and services. The most recent example of a deflationary economy is Japan in the period from 1991-2001. A collapse in the stockmarket and property prices resulted in falling earnings, then lower demand and falling prices. When prices are falling, purchase decisions are deferred in the expectation of prices being lower in the future, which causes prices to fall further. Since interest rates were already close to zero and the currency was depreciating, economic growth basically ground to a halt.
With the measures to counter the spread of Coronavirus having caused a number of businesses to lay off at least some of their workforce (while other businesses will not even survive), unemployment is likely to rise. Meanwhile demand is expected to be weak but supply remains robust, which leads to downwards pressure on prices. Such pressure is exacerbated by those businesses supported by cheap public money being able to continue with loss-making activities and therefore to cut prices.
Deflation would make recovery from the pandemic more difficult, as it acts as a brake on economic growth at a time when growth is what is needed to rebuild economies. Given the choice, it is therefore more in the interests of policymakers to opt for inflation than deflation.
The market gets a vote too
Of course, what policymakers want to happen is one thing. What free markets do is something else entirely. Just as few investors are likely to have missed the dramatic plummeting of share prices in March (particularly when their advisers were required to tell them about every 10% fall), they have witnessed a remarkable recovery of those prices in the subsequent three months. This is despite the huge dip in GDP (in the UK at least) that exceeds even that of late 2008. The market comprises a multitude of participants all trying to position their portfolios to meet their own objectives. If we accept that it is the most effective way of determining prices, maybe investors are bidding up prices (of companies which they anticipate being supported by taxpayers’ money for some time yet) because they expect their real value to be hit by a rise in inflation and they are trying to pre-empt that.
If deflation is indeed the future, then the market must be wrong; deflation, a recession and rising share prices are not compatible. If deflation increases the value of money, then just as the prices of goods and services will fall, so will those of assets. This implies a further crash. If the markets are right, it implies higher inflation.
In the next piece, I will look at what steps investors might reasonably take to protect themselves against either scenario.