Managers move to defend against inflation, governments to use it

The danger of inflation being used as a tool to reduce government debt is once again being talked about as economic recovery starts to take hold in developed markets such as the US.

Markets started the New Year in a decidedly bullish mood, having apparently side-stepped a series of risks which weighed on sentiment at the back end of 2012.

From the abatement of the Euro crisis to the avoidance of the fiscal cliff in the US, and a number of other technical and geo-political hazards inbetween, investors globally appear to be convinced that an upturn has begun.

Even better for them, central banks worldwide seem prepared to wait a little longer to ensure that recovery is secure, putting off terminating their quantitative easing programmes and other measures, and keeping key interest rates at record low levels.

Such generosity is now making some investment managers uneasy, and many are moving to defend their portfolios from a sudden spike in inflation. Most insist it is not an imminent risk, with notable differences among markets (France, for example, just posted lower than expected inflation data), but they are ready to lose the last few marks on the upside to take a prudent course.

Bill Mott, the highly regarded manager of the UK-based £309m PSigma Income fund, has warned investors and savers an inflection point is approaching which could cause inflation to spike.

UK’s CPI measure of inflation jumped unexpectedly to 2.7% in November, prompting warnings of a leap to double-digit territory in the coming years.

Mott points out that central banks’ quantitative easing is now unlimited, notably in the US, where the Federal Reserve is buying $40bn of Mortgage Backed Securities and $45bn of Treasuries per month. At an annualized rate, this amounts to a “suspiciously handy” 90% of the 2012 Federal deficit, he said.

He adds that the Fed has explicitly said it will keep interest rates near zero until unemployment falls to 6.5%. Even if this is a sensible target, interest rates are the wrong tool to achieve such a goal as it opens the prospect of interest rates staying too low for too long.

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