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Why inflation is the enduring mystery of recent years

Richard Flax, Chief Investment Officer, Moneyfarm

As I’ve said before, the absence of inflation in Developed Market economies is one of the enduring mysteries of recent years.

Even as wage growth in the US has accelerated, inflation has consistently remained at or below the US Central Bank’s 2% target. This has allowed (or forced) Central Banks to keep interest rates lower for far longer than most people had expected.

We’d argue that the path of inflation, and the US Federal Reserve’s response to it, will continue to be pretty significant for financial asset prices in the future.

It should really be an important caveat to most conversations about the value (or perceived lack-of) of investments in financial markets. For instance, when the Chief Executive of Blackrock says there’s more of a risk that financial markets ‘melt up’ rather than ‘melt down’ (rise sharply, in other words), he should really add the caveat “provided inflation remains subdued”.

People don’t say that, partly because no one really seems to expect inflation to accelerate.

Why does it matter?

Inflation and inflation expectations matter for a few reasons.

Firstly, it’s always worth remembering that inflation hurts the poor most of all – particularly inflation in food, energy and housing. It’s a point that Brazil’s ostensibly left-wing President Lula used to make as he kept Brazil’s Central Bank focused on lowering inflation.

Secondly, inflation and inflation expectations usually play a critical role in interest rate policy. We saw that most clearly towards the end of last year, where tighter monetary policy prompted a sharp drop in inflation expectations, and helped drive a shift in US monetary policy.

Thirdly, so-called “risk-free rates”, often defined as 10-year government bond yields. These are partly set by inflation expectations and help set prices for a broad range of riskier financial assets (at least in theory).

What does it all mean?

Basically, if inflation stays low, interest rates will likely stay low, which will be supportive for riskier financial assets like equities and high yield bonds, on balance. And if inflation accelerates faster than people think, then we could see the reverse – which could be uncomfortable.

Inflation vs Inflation Expectations and the US Fed?

Ok, this is more interesting. For the past 20 years, developed market Central Banks have basically said that monetary policy operates with a lag (say 12-18 months). Therefore, if they think inflation is going to accelerate above their target, then they need to move preemptively.

Hence the intense focus on inflation expectations, almost more than the actual current level of inflation. And this logic (or at least something similar) has driven the recent tightening we’ve seen in the US.

Now we’re beginning to see signs of a shift. There are a couple of options – the first idea is that the Fed should look at average inflation – in other words, if inflation undershoots the target 2% level, then maybe you shouldn’t hike rates until it’s spent time above that level.

Another option is that the Fed should be driven more by actual inflation, rather than expectations; only hike rates when you can really see inflation in the economy.

You could argue that part of this debate is driven by the deflationary experience in Japan in recent years, where the Japanese Central Bank has proven unable to generate inflation through monetary policy. There’s also the absence of inflation in the US in recent years – the decision to stop hiking rates clearly came as a surprise.

Some argue (our friends at AGI, for instance) that the Fed has already broken with its historical behaviour by ceasing to tighten even though the economy looks quite strong on various metrics.

In any event, these are some of the issues that are currently under discussion at the US Fed (led by Vice-Chair Clarida). We should get some comment from the Fed in the third quarter of this year.

What does it mean for financial asset prices?

A world where interest rates stay lower for longer should be supportive for financial assets all else equal – and probably allows equities / high yield to do better than low-risk assets.

There are a few caveats – first, all else may not be equal. As we’ve noted before, if interest rates stay low because growth is weak, then maybe we’ll see corporate profitability suffer over time.

Incidentally that probably also means that companies that can generate growth should outperform the market average – even if they are more highly valued.

The political point is also relevant. If policy benefits continue to flow predominantly to asset owners, should we expect to see a political backlash? Maybe we already are.

And finally, if you wait for inflation to arrive before you tighten, maybe Central Banks will move faster, later. The party goes on for longer, but the hang-over is worse. 

At Moneyfarm, we continuously monitor the markets and economic backdrop to ensure portfolios are properly positioned to make the most of global opportunities as they emerge, and minimise exposure to risk. Of course, we know the value of our model portfolios will probably fluctuate over the long-term, but we aim to keep this volatility within levels outlined by our Investor Profiles.

It’s all about taking on the right amount of risk for your risk profile, which is often closely linked to how long you want to invest for. At Moneyfarm we certainly believe a long-term strategy can give an investor an elusive edge. If you want your money in 12-18 months, it could be more appropriate to keep your money in an easily accessible cash savings account.

In December, our Investment Consultants had a number of conversations with investors concerned by the volatility experienced on financial markets as investors feared the Fed’s approach to monetary policy would choke economic growth, a key driver for equities.

If you had been tempted to sell during this volatility, you’d have accepted the losses. However, if you’d have given it a little time, you’d have seen the model portfolios recover, buoyed by the markets tipsy on the change of direction from Central Bank policy. This backdrop helped Moneyfarm to achieve one of the strongest quarters ever seen for its portfolios, as US markets enjoyed their best start to the year since 1998 and best quarter since 2009.

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