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The inflation threat

FEATURE: Dominic Picarda finds out whether the threat of inflation is upon us again

From deflation to inflation

Admittedly, the biggest threat in the past couple of years hasn't been inflation, but deflation. As we discussed , the credit crunch has put downward pressure on prices right across the western world and beyond. Fearing a repeat of the deflationary Great Depression of the 1930s, central banks and governments have fought back furiously. But their anti-deflationary efforts could end up causing the opposite problem.

Lowering interest rates to close to zero and printing money in order to buy up government bonds may have averted a prolonged slump – at least for now. But there are fears that rampant money creation will end the way it always has done previously. When more cash chases the same amount of goods and services, money clearly becomes worth less. Sooner or later, businesses and households get wind of what's going on.

As the price of life's essentials begins to rise, workers demand wages increases in order to keep up with the rising cost of living. Firms pay their employees more, and make up for it by further raising the price of the goods and services they sell. This in turn leads employees to demand even greater pay. A vicious circle of rising prices and wages is established, which can be hard to break, at least without a lot of pain.

A new inflationary world order

A determined fight against inflation in the early 1980s helped bring prices under control across the developed world. More recently, the collapse of communism and the growth of international trade have helped to keep inflation low. The huge number of workers who entered the world's workforce from the former eastern European bloc and China has helped companies to cut wage costs and the price of many goods.

However, in the coming years developing countries may help cause inflation rather than restrain it. Demand from nations such as China for natural resources like iron ore and copper could send the price of these essential resources soaring even higher. And as fewer new workers enter the labour market in China and elsewhere thanks to ageing population trends, wage costs are likely to increase, which companies may pass on as higher prices.

Deliberate inflation

Those with a cynical – or maybe just a realistic streak – suspect that the plan is not only to prevent deflation but also to create inflation, and lots of it. Countries and households across much of the world have enormous debts. Reducing these to more manageable levels by working hard and paying them off would take a long time and a lot of pain. But inflation offers an alternative way to ease the burden.

Because debts are fixed in money terms, rising inflation eats away at their real value. Governments have pursued deliberately inflationary policies to shrink their obligations many times over the centuries. Inflation was used to ease the national debt burden following the Second World War, for example. Not only do some people believe that this is what the authorities will have to do again this time round, but they also reckon that's exactly what they should do, too.

While it may seem like an easy way out, using inflation to demolish debts causes great harm. One person's debt is another's asset, so inflating it away merely robs Peter to pay Paul. Society is no better off overall. And the disruption caused by high inflation plays havoc with economic life in the meantime.

Having fought long and hard to establish their credentials as inflation fighters, central banks may be reluctant to throw it all away. And, compared with the 1970s, politicians now have much less influence over monetary policy. Interest rates here are now controlled by the independent Bank of England, rather than by a government with one eye on the next election.

Living with inflation

Over the past 25 years or so, we have become used to falling or low inflation. Price stability has allowed interest rates to fall, allowing the economy to grow faster and with fewer interruptions. Cheaper money has boosted the stock market, the bond market and also housing. In fact, low inflation and its benign effects are now taken for granted by many people, particularly younger folk, who have never known anything different.

As and when inflation returns, therefore, you will need to be ready to change your behaviour accordingly. For employees, this means becoming more forward-thinking and assertive in your wage negotiations. If you lack the clout to negotiate better terms for yourself ahead of whatever annual adjustment your employer tries to get away with granting you, consider joining your workplace's union to protect your position and your salary.

In particular, if you get a strong sense of rising inflation around the corner, try to arrange your savings and borrowings accordingly. A fixed-rate mortgage is obviously preferable if secured at a favourable rate, as you will not immediately suffer the inevitable rate rises as inflation surges. At the same time, you want your savings to be earning a rate that tracks market rates as closely as possible.

Inflation and shares

High inflation is generally bad for the stock market. There have been seven episodes of high inflation in the US since 1775. Stocks lost value during five of them. The only two occasions when equities prospered occurred more than 150 years ago. On average, the US market has lost a painful 8 per cent a year in real terms during inflationary shocks.

The strongest burst of inflation to date – in the 1970s – was a disastrous time for shares on both sides of the Atlantic. In the UK, the stock market lost 40 per cent of its real value over the 12-year period as a whole. At its worst point, the market shed more than two-thirds of its value, after adjusting for inflation.

Inflation is bad for equities for several reasons. Companies cannot always pass on rising costs quickly enough to their customers. This squeezes profit margins. Rising inflation also forces the authorities to raise interest rates, which can easily tip the economy into recession. This too can affect company profits.

When a higher interest rate is used for valuing companies' future cash flows, the present value of those cash flows falls. In turn, this reduces the valuation multiples that investors are willing to pay to buy shares. For much of the 1970s and early 1980s, shares therefore traded on very low price to earnings ratios.

Of course, not all companies are affected in the same way by high inflation. Certain industries perform much better than others in an environment of rapidly rising prices. Textbook theory says that those best placed would be those with the best pricing power, as they would be able to protect their profit margins by passing on costs to their customers.