Cash as inflation protection

What’s the best way to protect ourselves against an inflation scare? The answer, surprisingly, might be to hold cash.

One reason I say this is simply that inflation is worse for other assets.

Conventional bonds would obviously be hurt because if investors were to fear higher inflation they would dump assets which offer fixed nominal pay-outs.

Nor is it obvious that index-linked gilts offer protection from unexpected inflation. Yes, they do if we hold them to maturity – albeit at the expense of suffering a guaranteed loss in real terms if such unexpected inflation does not materialise. If we do not hold them to maturity, however, we could lose. It’s quite possible that a rise in inflation expectations would see both conventional and index-linked yields rise, especially if investors fear higher inflation around the world. In this scenario, we’d see losses on linkers.

We shouldn’t look to gold to protect us either. The key fact about the metal is that it pays no interest. This isn’t much of a drawback when bonds don’t yield much. As bond yields rise, however, it becomes nastier: the opportunity cost of gold increases. For this reason the gold price falls when yields rise. Which means the metal will do badly if inflation expectations rise.

This should not be surprising. If gold protects us from inflation, it should have fallen in price after the early 1990s as the threat of inflation diminished, and should have risen in recent months as investors have become more worried by inflation. But in fact, the exact opposite happened. Yes, gold protects us from falls in investors’ appetite for risk – but not from inflation.

Nor can we rely upon equities protecting us. Yes, in recent years these have done well when inflation expectations have risen. But this has been because such rises have occurred during economic upturns. Before the mid-2000s, it was common for rising inflation expectations to see shares fall because investors feared that higher inflation would cause higher interest rates.

Which is a reason why we cannot rely upon foreign currency either. If higher inflation expectations lead to expectations of higher rates, sterling might well rise thereby imposing losses on holders of foreign currency. Yes, the textbooks tell us that if one country has higher inflation than another its exchange rate should fall. But if this is true at all, it is so only in the long run. Nobody got rich betting on it being true over shorter periods.

So, it’s possible that an inflation scare will see all or many assets other than cash do badly.

History warns us of this. When inflation expectations rose in 1989-90 equities, gold and both conventional and index-linked bonds all fell. The same thing happened even more markedly in 1994: rising inflation expectations then saw big losses on equities, gilts, gold and US dollars.

Yes, these episodes were a long time ago. But that only tells us it’s been a long time since we had a serious inflation scare.

All this tells us that cash might protect us from inflation in several ways.

First, the worst-case scenario for cash is better than the worst-case scenario for other assets. The most you can lose on cash in real terms is simply the real interest rate, which is most unlikely to be more than minus 5 per cent over 12 months. But you can easily lose more than 10 per cent on gilts, gold or equities over a year.

Secondly, cash protects us from correlation risk – the danger that assets will lose us money at the same time. We’ve become accustomed to thinking that equities and gilts often move in opposite directions and so it is easy to spread risk. But this isn’t guaranteed. In the 1990s equities often fell at the same time as gilts or gold. And as we saw in 1990 and 1994, such combined losses are especially likely when investors run scared of inflation. Cash saves us from this.

Thirdly, if the Bank of England sticks to its 2 per cent inflation target it will eventually raise rates in response to inflation fears. And what’s more, it will raise them by more than the increase in inflation, because it is a rise in the real interest rate that tightens policy and reduces inflation. In this way, higher inflation should raise real returns on cash.

Granted, the Bank will be slow to respond to inflation. But if it does its job returns on cash will rise. We cannot say the same for other assets.

Of course, you might think there’s a risk the Bank won’t do its job. Or you might think – more plausibly in my opinion for what that is worth – that inflation expectations will fall back rather than intensify. Either view would support holding equities.

And of course, I am only considering short-term asset allocation – by which I mean a year or two. In the long term we protect our wealth with assets that offer positive real returns. And equities are our least-worst hope here.

Nevertheless, if you are worried by the possibility of another inflation scare, you should hold at least some cash.