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Great expectations: How much should you fear inflation?

Inflation: Nearly always going up

A tired but trusty metaphor for policymakers using interest rates to control inflation is that it’s a bit like pulling a brick across a table with a rubber band.

Think about it: Pull, pull, nope, nothing, “Are you sure this rubber band is really attached to it?” then – WHAM! – a brick flying towards your face.

That’s inflation for you. It can ramp up far faster than expected, and it’s non-trivial to stop it once it does.

A little bit of inflation is considered good for an economy. By slowly eroding the value of money, it forces those who have it to put it to productive use, rather rather than hoarding it under a mattress (or in gold for that matter).

Inflation is also favoured because the alternative – deflation – is a nasty and unsolved problem in economic policy. Just ask the Japanese.

Finally, governments like inflation because it erodes the value of outstanding public debt, and with far fewer complaints from voters than the alternatives of raising taxes or cutting spending.

But high inflation can be ruinous to investors, and really high inflation can wreck entire countries.

Inflation ahoy? Who knows

You may be reading this in February 2011, or you may be reading it in 2020, or on any day in-between. Whatever the date, I guarantee that someone out there is writing that inflation is about to go much higher.

Like the poor, the fear of inflation is always with us. Sometimes it proves well-founded, and the various mooted causes – rising commodity prices, excess liquidity, low interest rates, labour shortages, and many more – turn out to have been spot-on.

At other times, the trigger – low unemployment, say – doesn’t produce the inflationary spiral that the inflation-wary expected. The first decade of the 21st Century was much like that.

But it’s no surprise to me that it’s so hard to predict inflation. Our main tool against it is interest rates, and interest rate expectations are intimately linked with government bonds.

If you could know with any degree of certainty that high inflation is on the way (or, equally, that it’s definitely not) then you could capitalize on it by buying or shorting government bonds.

It’s a very simple trade, with few other risks associated with it – unlike investing in shares or corporate bonds, say.

For that very reason, tens of trillions of dollars is wagered in the government bond market worldwide, utterly dwarfing the equity market. This bond market sucks up the brainpower of thousands of smart people who are paid a small fortune to guess the direction of interest rates.

If you think you know better than this vast voting machine because, for example, you read on a blog that Mexicans are having a stand-off due to a tortilla shortage, then please get over yourself.1

Over the top inflation

Another problem for DIY inflation forecasters is that inflation has wicked feedback loops.

Fears of high inflation can become a self-fulfilling prophecy, as workers push for higher wages and consumers and companies start stockpiling. Alternatively, the prospect of higher interest rates to come to tame the inflation can curb spending and borrowing, and stop companies investing in expansion – even before rates have moved by very much.

Spare a thought for Central Bankers, who are tasked with having a monthly stab at it. The Bank of England got it right for a while, but for the past few years it’s overshot the target more often than an English striker in a World Cup match.

Perhaps that’s not surprising, given the recent climate: The usual mental Jenga of setting rates to try to influence inflation in 12-18 months time has been complicated by a financial meltdown that threatened to send us back to the Stone Age (or at least the gold standard). Mystic Meg would have got a migraine.

In 2009, for instance, I feared quantitative easing and record low rates would eventually spawn inflation in the UK (and loaded up on shares on the back of it) but it’s hard to prove the link so far. Yes, we have high inflation as I write, but it’s mainly imported through the weaker pound and higher commodity costs, topped off with the impact of VAT tax changes.

UK QE can be blamed for the weaker pound, but it hasn’t driven the oil price. And for its part the US has so far seen very little domestic inflation, despite its own massive QE operations and super-low interest rates.

But – and appropriately, for our American cousins, it’s a big but – the size of the US economy means in contrast it IS conceivable that cheap dollars are putting a light under commodity prices and emerging markets, and thus that US QE is fueling inflation that will be imported back home.

Conceivable, but so far unproven. All we know for sure is that inflation in the US has yet to spiral out of control, despite two years of pundits egging it on.

Well, apart from those many pundits who feared deflation, of course. I mocked them at the time, but as I said at the start you try to predict inflation and interest rates at your peril, so it doesn’t pay to be too smug.

Inflation always takes the house

In summary, sometimes the inflation hawks (those who want to raise rates to head off inflation) turn out to be right, and sometimes the doves (those who’d dial rates back because they don’t see any threat from rising prices) are the ones who can say they told you so.

History, as ever, remembers the winners. Still, that’s more than most bloggers, who seem to remember neither the winners nor the losers, but rather just that morning’s headlines.

Instead of being a hawk or a dove on inflation, as private investors we should play chicken to protect our wealth. This means having a healthy fear of the consequences of inflation, but not going crazy at every headline (that just makes you a headless chicken).

In particular, don’t let short-term stock market phobia cause you to invest too much of your long-term savings in low-yielding and/or fixed rate investments that have no ability to respond to inflationary shocks. Shares are much more volatile over the short run than bonds, but they more than make up for it by offering some protection from ever-rising prices over the long term.

In most of the world, for most of modern history, inflation has inexorably reduced the value of money over time, like water dripping onto an apparently impervious stone floor. It’s how your grandfather bought his first 3-bed house for £1,000, and it’s why your father thinks you spent too much on yours.

Drip. Drip. Drip.

Worried? Read my 10 ways to stop inflation eroding your wealth.

  1. Note: I speak as someone who regularly does have a guess! I am only human, and not quite over myself. []
{ 9 comments… add one }
  • 1 lostinmidlands February 3, 2011, 9:50 am

    “Shares are much more volatile over the short run than bonds, but they more than make up for it by offering some protection from ever-rising prices over the long term.”

    Yes, historical long-term stock returns have tended to be higher than long-term bond returns. But how accurate is the folk wisdom (i.e., the morning headlines) that shares offer (pardon, should be: have offered!) better (long-term) protection from inflation than bonds?

    http://www.bondvigilantes.co.uk/blog/2011/02/01/1296576900000.html

  • 2 Alex February 3, 2011, 3:40 pm

    Your brick/rubber band combo sounds like it has health and safety issues.

  • 3 Nanette Byrnes February 4, 2011, 6:33 pm

    Nice overview on a complicated topic. Reminded me of this interesting piece on Bernanke’s blaming supply and demand (and the weather — just like jobs!) for inflation abroad. The comments are worth a glance too — many see Fed policy as far more influential than Bernanke wants to acknowledge.
    http://blogs.wsj.com/economics/2011/02/03/bernanke-dont-blame-me-for-higher-food-prices/
    Cheers.

  • 4 The Investor February 4, 2011, 11:28 pm

    @Alex – Yes, this is why you never see an economist who is also a model. Face like putty by 25.

  • 5 The Investor February 4, 2011, 11:35 pm

    @LostinMidlands – Interesting link, thanks, which I’ve added to Weekend Reading for tomorrow.

    But I’d note they are looking at one year returns when they say equities do worse at combating inflation. That’s a very short timeframe in my view to make solid predictions about, or to hold equities over for that matter. Given how unpredictable inflation is (as discussed above) I don’t see the benefit of trying to shift assets on a 12 month view in response to it.

    Equities are best in the very long term, but as we’ve seen in recent times that can mean a couple of decades in the direst scenarios!

    I also like how they give cash a place. As I’ve written before, it’s a very underrated tactical asset class, even in inflationary times. Of course, you need a central bank to actually be combating inflation with higher rates for it to have a fighting chance.

  • 6 The Investor February 4, 2011, 11:42 pm

    @Nanette – Thanks! Will have a look at that article now.

  • 7 Ronald R. Dodge, Jr. February 7, 2011, 8:33 am

    As for our USA nation, I do foresee significant inflation down the road, but not in the immediate future. What do I mean by this?

    From 1920 to 1934 was all mostly the same as what it was from 1999 to May of 2010.

    First, you had all of very high demands in 1999 that was unsustainable (remember the major labor shortage in 1999). Next, you had business managers expecting sales to go up another 20% for the year of 2000 as they were planning on this in the 4th quarter of 1999. One manager specifically asked me to do that very thing with the numbers. I was the new person on the block, so I didn’t question it, but yet, I was asking myself, “Where does he see this? I see sales going down, not up in 2000.” I didn’t know by how much, but I saw it coming given the very high demand in regards to the extreme fear factor with regards to the Y2K issues.

    Sure enough, in 2000, sales went through the floor, plummeting like crazy. Managers kept putting it off saying it will happen in the last quarter of the year, but then came September/October, and that’s when they came out saying such sales weren’t going to take place (Do you remember the stock market dropping like crazy in October 2000?).

    Markets kept dropping until about October 2002 as the market went into a sideways trade. October 2003 then went up majorly, but that up was based on borrowed funds given interest rates were held down far too long from 2001 when they dropped such rates. Rates didn’t start going back up until 2005, which was already way too late. Not only that, but bankers ignored the checks that were put in place in the 1930’s after the issues that caused the Oct 29th, 1929 one day drop. As such, too much money was lent out as well as the bankers got greedy and the consumers didn’t do their proper homework prior to taking out mortgages.

    As such, stock markets dropped from Oct 2007 to Mar 2009 (just like Aug 1929 to July 1932). However, this is were the commonality start to break off as in the Great Depression days, they didn’t have the resources for bail outs, but had to come up with other creative ways, which they didn’t fully recover until 1947 (15 years from business bottom or 14 years from family unit bottom).

    This time around, the federal government first bailed out the banks. While I didn’t like it, I also realized from a national security stand point of view, the government about had to bail them out. Then the auto indistry cried out saying they need to be bailed out. While I lived through the situation that took place in Genesee County (Flint, MI area) in the late 1980’s, I still didn’t and still don’t agree with the bail out of the auto industry by the government as this bail out didn’t teach the managers of such industry a thing other than they can just rely on the government to save them. They never have learned their lessons going back to Edward Deming back as early as 1964 (before I was even thought of), and they still haven’t learned their lessons. All the bail out did was delay the inevitable of the ripple effect of unemployment, which why do the bail outs if it’s not going to stop the unemployment ripple effect, but rather just slow it down, and the nation be hurt that much more than it would have been if the government didn’t bail them out.

    Given all of the different bail outs, foreclosures, and bankruptcies, businesses have to make up for such losses, which to make that up, they have to raise their prices to overcome such issues. Raised prices is essentially inflation in many ways. While there’s too much unemployment right now, I do foresee major inflation down the road within this particular economic recovery stage. It’s not a matter of what, but more so a matter of when. This recovery time period I expect to take between 5 and 10 years from the family unit bottom, which happened in May 2010. We may not see this inflation for the next 2 or 3 years, but I still expect it down the road within this economic recovery stage.

  • 8 MoneyStar February 8, 2011, 1:23 am

    Certainly the goal is inflation over deflation, and with the velocity of money not being where it had been in years past the fear of hyperinflation doesn’t make hold up. Taking a patient and long-term investment view is the best thing one can do during these times.

    When looking at the SimplyFinance community, it looks like its users believe that investing in businesses (and not gold and other non productive assets) makes the most sense.

  • 9 Roger, the Amateur Financier February 10, 2011, 11:26 pm

    An interesting discussion of inflation and the related fears that go with it. I have no doubt that inflation will return at some point (perhaps aggressively, although as noted, there hasn’t been any indication of such as of yet), but for now, I think worries about impending ‘hyper’-inflation are rather overblown. Good, thought provoking article.

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