The outlook for inflation and implications for investment strategy

It is this creation of money that is contributing to inflation concerns, albeit that enlargement of the monetary base has given rise to the appearance of over-valuation (‘bubbles') in asset classes such as bonds and emerging-market equities rather than to expansion in the manufacturing and services sectors. However, stripping out the ‘excess reserves' deposited with the Federal Reserve, which reflect the desire of banks not to be caught out by another liquidity crisis, the growth in the monetary base is actually modest. In short, because the desire of banks to hoard cash has increased (and arguably too because borrowers are intent on repaying their debts rather than increasing them), credit creation by the private sector is constrained. This is in no small part attributable to governments' requirements for commercial banks to be recapitalised and to hold more capital (and to hold it in more liquid form). Credit creation and lending policies consequently are somewhat enfeebled.

The marked decline in demand in the autumn of 2008 and spring of 2009 created significant spare economic capacity, both in the developed and developing worlds. Thus, the possibility of a shortage of ‘normal' industrial goods and commercial services seems distant and an unlikely source for the revival of inflation. In isolated areas, there are upward pressures on prices, for example in UK housing, where a shortage of supply and low yields on cash have arguably forestalled what would otherwise have been a larger price decline, and in certain foodstuffs such as tea and cocoa. In the absence of an unexpectedly vigorous increase in economic activity, such strains appear, however, to be containable.

Similarly, despite unemployment not having risen as much as might have been expected given the severity of the economic downturn, there is, in the private sector at least, no sign of wage inflation. Indeed, many companies have stated their resolve strictly to limit any pay increases in 2010 and wage restraint is evident in official earnings data. The public sector has been less affected than the private sector but, whatever the hue of government in the UK following the general election, there is almost certain to be an attempt to exercise restraint over rewards for the public sector. As events in the ‘olive belt' of Europe are demonstrating, the UK is by no means unique in this outlook.

Debt-raising activity by numerous governments around the world, and the gradual cessation/withdrawal of stimuli, should limit price pressures. However, the obsession of central bankers with consumer-price-related inflation targets, together with a desire to support employment, entails a tendency towards excessive policy stimulus. This tendency may be particularly extreme in the current environment, given that the large ‘overhang' of unemployment and spare industrial capacity appears to afford policymakers ample scope to maintain loose policy. Current policy in the UK does give rise to some concerns about medium-term inflation risks, especially given the desire of the authorities to generate growth and the bias to tighten monetary policy too late rather than risk deflation.

Inflation may enter through the ‘back door', via changes in exchange rates both in emerging markets (where currency controls have preserved export potential but begun to raise the cost of imports) and in developed markets where domestic demand outstrips domestic supply. The UK is more vulnerable than many countries, given its lack of growth, the magnitude of its public debt, the openness of its trading system and the service-oriented nature of its output.

A balance of equities, property, commodity-related assets and, once they offer greater value, index-linked gilts should provide an each-way 'bet'; if inflation does not take hold, such asset classes should engender healthy, long-term returns. Should inflation return, all asset classes would be tested, but those which offer long-term, real returns are likely to be favoured.