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The cost of inflation illusion

Even though inflation is low and stable, investors can make big mistakes by ignoring it.
November 28, 2019

Investors go wrong because they systematically misjudge inflation, according to new research. Henning Cordes at the University of Munster says they “largely ignore future inflation.”

He and his colleagues established this in a series of experiments in which subjects chose how much to invest in a risky asset. They found that when people were presented with nominal expected returns and the prospect of inflation they invested more in the risky asset than they did when presented with real returns, even though the amounts of future consumption at stake were the same. In this sense, inflation leads people to buy more equities, because it fools them into thinking they’ll be better off when in fact they won’t.

Put it this way: Which would you prefer? An asset that offers an expected return of 55 per cent over the next five years with a less than five per cent chance of a loss over this period? Or one that offers a 38 per cent expected return with a 12 per cent chance of a loss? Clearly, the former seems better. But in fact, I’m describing the same asset – the All-Share index since 1990. The only difference is that the former ignores inflation and the latter doesn’t. But the latter is a better description of how much you’ll be able to buy in five years’ time. And this is surely what really matters.

Now, this idea that inflation makes equities seem more attractive appears to contradict two historical facts about higher inflation: that it has usually seen share prices fall relative to dividends; and that it has often raised the savings ratio. Both facts suggest that people expect lower returns when inflation is higher.

In fact, there’s no contradiction. Higher inflation is usually associated with greater uncertainty, and uncertainty reduces share prices and raises savings. Where there is no uncertainty – where we face steady inflation – inflation can make equities seem more attractive than they really are

This can be a dangerous error. It causes us to overestimate future returns and save too little, and discover too late that our pension pot won’t buy us as much as we thought. If you overestimate returns by just 2 per cent per year, then in 20 years’ time you will only be able to buy two-thirds of what you expected. And if the Bank of England sticks to its target, 2 per cent inflation per year is what we’ll get.

Inflation might be low and stable now. But this doesn’t mean it does no damage. Our misunderstanding of the long-term effect of even low inflation can cost us a lot.

Luckily, there’s a solution to this. We should think about future returns on all assets only in real terms. So, returns on cash are negative: the Bank of England is imposing a wealth tax. And our best expectation for future equity returns should be that prices over the long-term won’t rise in real terms by much more than real GDP, if that. This implies a real gain of less than 2 per cent per year, and around a one-in-three chance of losing money in real terms even over a 10-year period. Most future returns on equities will come from dividends. If you are spending these, therefore, do not expect significant long-term capital gains.

Economists sometimes speak of a “classical dichotomy” – a sharp distinction between real things, such as output and claims upon output, and nominal ones such as prices. Investors should remember this.

The prospect of such low returns will depress anybody who has been prone to inflation illusion. But there is also a cheerful message here. It means we should celebrate the low inflation we’ve enjoyed since the 1990s, because the lower inflation the smaller is the cost of money illusion. Perhaps, then, low inflation is better for us than we’ve supposed – and its achievement is a rare sign that there has been progress in economic policy-making.