Beware the long term inflation threat, allocators warn

The threat of inflation surging in the long term as current monetary policies run their course is being flagged by a growing number of allocators.

Two things are certain about inflation in the developed world. One is that it is not a problem in the short term. The other is that it almost certainly will be, in the longer term.

Allocators generally agree that advanced economies’ near-term risk is one of deflation, but then almost inevitably will come inflation: ‘a ticking time bomb’. So when will it ‘explode’? No one can say, or at least is willing to say. But few doubt that at some stage its corrosive effects on investment portfolios will be felt.

But it will not happen yet, suggest economic forecasts from Germany’s DekaBank. Its economists predict a moderate 1.8% consumer price growth next year for both the eurozone and developed countries in general. American CPI will jump slightly more sharply, by 2.3%, it predicts.

William Yun, executive vice-president of the Franklin Templeton Alternative Strategies group, says any threat of rising prices is not an issue that comes up often with his unit’s clients yet. “But in the intermediate- to longer term [inflation] could grow significantly,” he says.

As a chart of US long-term inflation expectations from Natixis Global Asset Management shows, an upturn is expected (see right). This is not surprising. Since early 2008, the Federal Reserve’s stimulus policies have grown its balance sheet from $900bn to about $2.8trn. QE1 and QE2 together added $1.8bn, and Operation Twist added $400bn.

Aaron Gurwitz, chief investment officer of Barclays Wealth and Investment Research, says in the unit’s Compass report “a veritable ­mountain of money has been created in the past four years”. He adds that the velocity of money in the US seems to have declined, because of a surge in excess reserves that do not flow into the economy or contribute to inflation. But make allowances for this, and the velocity is actually above its long-term average of 1.8.

Gurwitz says: “Given an economy that still has a relatively healthy turn of its money stock, investors and policy makers cannot be complacent about inflation’s potential to appear, as the margin of error is smaller than the numbers would suggest.”

Philippe Waechter, chief economist at Natixis Asset Management, says: “Investors can imagine that, with the large amount of liquidity in the market, [inflation’s] management could be hard for the Fed.”

If the Fed is accurate in its forecasts, do not expect more than modest inflation until at least 2015: the central bank expects sub-2% rates until then. Waechter adds: “Before the ‘real recovery’, risks of inflation are low, because of the absence of pressure inside the economy. But after [that], with the combination of lax monetary policy and low unemployment below 7%, this can feed to higher inflationary expectations.”

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