Inflation – Feature
If gold prices are anything to go by, investors are certainly lack- ing confidence that current price levels can be sustained. Prices for the precious metal have risen by more than 35% year-to- date and demand for index-linked gilts has also surged. At the same time, rising prices of options for inflation swaps suggest that some investors have also not completely written off the possibility of a deflationary scenario.
While questions had already been asked prior to the Covid-19 crisis as to what extent record low levels of inflation could be sustained, the forced economic shut-down as a result of the pandemic has made changes in price levels more likely, with potentially dramatic consequences for fixed-income heavy investment portfolios. An early indication that price levels might be rising were infla- tion figures for July from the Office for National Statistics, which suddenly jumped to 1%, rather than the 0.6% predicted. While this is still some way off the Bank of England’s 2% tar- get, the crisis has fundamentally altered consumption patterns making it much harder to predict how prices for the traditional consumer price inflation (CPI) consumption basket might pan out.
“The inflation outlook for the next 12 to 18 months is probably the most uncertain it’s been in my 15-year career of trading inflation-linked products,” argues Evan Guppy, head of liability driven investing at the Pension Protection Fund.
Old school theories questioned
The problems of predicting price levels precede the pandemic. In the aftermath of 2008’s global financial crisis, while infla- tion targeting has been defined as the cornerstone of central bank policy making, macro-economists have struggled to come up with a coherent framework to understand what drives infla- tion. The experience of the past decades appears to have inval- idated the two dominant textbook theories, the Phillips Curve and the monetarist theory of inflation.
The theory of the Phillips Curve suggests that low unemploy- ment would lead to a rise in wages and hence drive up price levels. But the past decade or so has been characterised by rel- atively low levels of unemployment combined with stagnant wages and persistently low inflation across Western economies and Japan. Similarly, the monetarist theory of inflation, as popularised by Milton Friedman, suggests that an increase in money supply could drive up price levels. But the period following the 2008 crisis has seen record levels of money being pumped into the economy while price levels sank more or less continuously. Nevertheless, the 25% increase in money supply in the US alone is one reason why investors continue to remain wary about price levels.
Elina Ribakova, deputy chief economist at the Institute for Issue 96 | September 2020 | portfolio institutional | 29
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