From TCFP’s investment consultants, Cormorant Capital Strategies:
Inflation, as measured by the year-on-year change in the Consumer Price Index (CPI), stands at just 0.7% today. That being so, it is entirely reasonable to anticipate rising inflation. But will inflation be sustained at ‘high’ rates? The distinction is important.
The Bank of England’s Monetary Policy Committee (MPC) is tasked with promoting ‘price stability’. In that context the government has set the target for inflation at 2.0%. Moves away from the target rate by more than 1.0% in either direction are to be met with a letter from the Governor, addressed to the Chancellor of the Exchequer, explaining why inflation has moved outside of that range, the policy action the MPC is taking to bring it back into range, and the horizon over which that will likely happen. It is for this reason that I characterise inflation in the range of 1.0%-to-3.0% as being ‘well-behaved’.
In general terms, well-behaved inflation is beneficial for the capital markets (including the bond market) and central to the proper
functioning of our economy.
If I were to guess where inflation was headed over the next few years, I’d chance it would fall within the 1.0%-to-3.0% range. More precisely, my ‘central forecast’ calls for inflation in that range with brief spells equally distributed on either side. I am not discounting the possibility that inflation will overshoot or undershoot, but the further we deviate from the target rate the less likely I think it is in the first instance, and the more transitory I think it will prove to be in the second. To be clear, I do think that there is a meaningful probability that inflation will briefly exceed 3.0% in the next 12 months or so. Nevertheless, I am not at all fazed by that outlook.
The same cannot be said of the commentariat providing copy for the business pages, inside which there is a heavy emphasis on the threat from rising inflation. The threat is rarely quantified though, so we are left to guess at what point such anxieties might tip over into alarm. It is inconceivable to me that experienced professionals would be uneasy with inflation trending inside the 1.0%-to-3.0% range, so I will assume that those anxieties are focused on a breach of the 3.0% bound. That’s where concerns might be legitimately located and which are exacerbated in step from there.
What, then, are the chances that the headline rate of inflation exceeds 3.0% in the UK by the end of this year?
If my appraisal is correct, the boffins at the MPC’s disposal are speculating that the answer is roughly one-in-three, or 28%. That feels
about right to me.
Indeed, the consensus, in so far as there is a consensus, suggests that inflation will end the year at 2.2%. As is usually the case, the average that forms the consensus hides a diversity of opinion. The highest forecast I can find comes from Economic Perspectives (EP) and stands at 3.7%. Meanwhile the lowest, from the Economist Intelligence Unit, lies at 1.2%. It’s worth noting that the 3.7% projection from EP represents a distant outlier, with the next highest coming in at 2.6%. The same range of forecasts, this time targeting inflation by the close of next year, falls between 1.3% from Capital Economics and 5.2% forming another outlier from EP – the next highest rate for 2022 is 2.7%. The average amounts to 2.1%.
So, neither the Bank of England, nor the bulk number of outside economists expect inflation to breach 3.0% as a matter of course. Nevertheless, if I were able to poll those economists directly, I am sure that they would all acknowledge an unusual amount of uncertainty at present and I suspect that the majority of them would similarly acknowledge at least a realistic risk of a super-3.0% rate.
Of course, the past is not at all a reliable guide to the future, but context is never wasted. Accordingly, let’s take a look at how the CPI measure has moved over the course of the last few decades.
Starting in Mid-2003, when the Bank of England’s MPC was first tasked with holding CPI between 1.0% and 3.0%, the average rate amounts to 2.1%. That represents a remarkable degree of success for the MPC and the framework in which it operates. The policy of inflation targeting allied with independence from government are central to that success.
Even so, the maximum rate over that timeframe amounts to 5.2%, a peak rate which was reached on two separate occasions, both of which I remember well. The first is associated with the 2008 Financial Crisis and a precipitous 30% decline in the pound’s exchange rate. During that episode, inflation first exceeded the 3.0% mark in May 2008, hit its peak in September and fell back to 3.0% in March of 2009. During the second episode, CPI was to exceed 3.0% between January 2010 and March 2012 and was, on this occasion, associated with a stable pound but oil prices had climbed from around $50 to more than $125.
Barring the single month of March 2007, those are the only occasions when inflation has breached the 3.0% bound. The record counts 37 months of super-3.0% inflation from a total of 213 months, or around one-in-five. The longest continuous streak lasted for 25 months. The context then, is that since the turn of the century, inflation in excess of 3.0% has proved comparatively unusual, comparatively short-lived, and always associated with some kind of exogenous shock.
And, of course, a global pandemic represents exactly that; it is a huge exogenous shock.
As that shock reverberated across the world’s capital markets and the government’s response morphed into one of harsh economic and societal restriction, the Bank of England acted to underpin the proper functioning of the credit market and to ease business conditions more broadly. It forced interest rates to record lows at both the short and long end of the yield curve. Bank Rate has been held at 0.1% since March last year and it was around that time that the yield on the 10-year gilt dipped toward 0.2%, aided by an expansion in the Bank’s asset purchase programme from £445 billion to £645 billion initially, and onward to £895 billion more recently. Those numbers are jaw-dropping. And those jaw-dropping numbers are the source of some nervousness for inflation hawks, particularly in the light of what appears to them to be a complacent narrative among central bankers. The MPC, for instance, ‘does not intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in… achieving the 2.0% target sustainably’.
In my view, those most fearful of high and sustained inflation often fail to account for the counterfactual. What would inflation be today had the Bank not acted in the way it did? Might we be in the grip of a depression? Might we be faced with falling prices? That seems to me to be a reasonable assumption. Instead of present-day inflation of +0.7%, we could be looking at a -0.7% rate or worse. In that case the +0.7% we see today amounts to a 1.4% differential. It may be that at least a part of the inflation they fear is already here.
Other balancing forces are present. Whilst Bank Rate remains locked at 0.1%, longer-term interest rates have already moved markedly higher. The 10-year rate has climbed from 0.2% to 0.8% and the 15-year rate has moved from 0.4% to 1.2%. Sterling too is trading much higher, up from $1.22 a year ago to $1.40. Meanwhile today’s below-par inflation already coincides with a year-on-year increase in oil prices equal to a whopping 78%.
I have no doubt that the MPC’s bias is toward inflation which is above target rather than below target. I have no basis on which to make this assertion, but I suspect that the collective will happily tolerate CPI up to 2.5%. I think I detect a consensus among policy makers at each of the big four central banks (the Bank of England, Federal Reserve, European Central Bank and Bank of Japan); it is one that acknowledges some asymmetry in their policy position. With interest rates at or close to zero and asset purchase programmes (QE) full to the brim, they are far better equipped in their endeavours to bring inflation down from above target than they are in lifting inflation up from below target.
There is indeed a risk that the Bank of England maintains too loose a policy for too long. But there is also a risk that they move too quickly in tightening policy.
To be fair, loose monetary policy is just one aspect supporting the high inflation hypothesis. Fiscal policy is aligned too. Government debt has sky-rocketed over the last 12 months or so. According to the Debt Management Office, the total nominal value of gilts in issuance amounted to £2,000 billion at the close of last year, 20% higher than at the close of 2019. With one month of the fiscal year remaining at the time of the last estimate, the Office for Budget Responsibility (OBR) notes that the Public Sector Net Borrowing (PSNB) requirement had reached £278.8 billion in the 2020/21 fiscal year. That compares with a PSNB requirement of £157.7 billion in the fiscal year following the 2008 crisis.
I’ve heard speculation that it is in the government’s interests to inflate away the debt. And while it is true that the government is keen to see positive inflation – that much is evident in the 2.0% inflation target – I am sceptical that our politicians are able to effect higher inflation on a whim, and that such a course of action would be without consequence. Notwithstanding the fact that around a quarter of the £2,000 billion debt is in the form of index-linked gilts, the British electorate are not going to take kindly to a government intent on letting the cost of living get out of hand. It is also worth noting that while the stock of debt, as a percentage of gross domestic product, is the highest it has been in more than 60 years, the costs of servicing that debt are the lowest they have ever been. The OBR puts that cost at just 2.4% of government revenues.
I hope I do not appear complacent about the risks in the outlook. In my view, those risks are indeed sufficient to warrant some hedging in retail investment portfolios.
There are two problems associated with hedged positions though. The first is that it is expensive to do so when crowds of competing investors are bidding up the prices of assets which might be expected to provide some protection. The second is that a hedged position is sub-optimal for other eventualities. Those problems combined carry a significant risk of poor performance.
That is why I am advocating for ‘limited’, rather than ‘extensive’, inflation hedging. I’ll adjust my position in light of any new evidence, but for now, it is more likely that we see inflation trend inside the 1.0%-to-3.0% range, and in that case a sensibly diversified portfolio already comprises sufficient protection.
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