Terry Smith annual letter: peril of inflation has been forgotten

Terry Smith, the founder of UK-based asset manager Fundsmith, and former head of the interdealer broker Tullet Prebon, has used his Annual letter to Shareholders to warn that a new generation of central bankers is ignoring the perils of inflation.

Smith, known for his “Straight talking”, in person and via his blog, warns the mandate of central banks in the developed world is changing.

He points out that the US Fed recently doubled its monthly QE programme to $85bn and said it would maintain this programme “at least” (Smith’s emphasis) until unemployment falls below 6.5%.

Shinzo Abe became prime minister of Japan for the second time with the stated intention of making the Bank of Japan target an increase in inflation.

Smith added: “Mark Carney, the much heralded new governor of the Bank of England, got off to an unusual start by announcing seven months before he starts work that he thinks there should be a debate about whether central bankers should currently be targeting nominal GDP growth i.e. ignoring inflation.”

“Now depending upon your point of view, this is either good news, because it means yet more stimulus will be applied, or bad news because you do not think the additional stimulus will do much to achieve economic growth or increased employment, but it will risk side effects which can be as bad or worse than the ailment they are seeking to treat.”

“I am in the latter camp,” said Smith. “I think that central bankers should be independent of government and should be concerned with the soundness of the currency, and if they have the regulatory authority, the soundness of the banking system.”

“Allowing them to stray outside that is dangerous as it will lead to confusion of fiscal and monetary policy, or in plain English, governments will be able to fund their profligate spending programmes by getting the central bankers to print more money and buy their bonds until the employment or nominal growth targets are achieved, or even beyond (note the term ‘at least’ used by the Fed).”

He sees the inevitable consequence of this is as inflation and currency depreciation.

“The newer generation of central bankers such as Mr Carney have yet to experience that. When they do, they may discover that when inflation takes hold, it does not conveniently stop at some predetermined target rate.”

“They may also find that the only device they have to control inflation is the blunt instrument of interest rates, and a significant rise in rates would have some interesting effects on the affordability of government debt, private debt and the economy in its current condition.”

Smith also acknowledges growing concern at a global currency war: “You might legitimately point out that depreciation of the major currencies is a bit tricky as they are all trying to depreciate against each other in order to achieve some competitive advantage. “

“But maybe they will all depreciate against hard assets, or to put it more simply – inflation,” he warned.

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