CAN INFLATION STAY UNDER CONTROL?

Q3 2020 Market Update




Q3 2020 Market Update

"The US Federal Reserve changes are just the latest chapter in a long effort to control inflation without doing too much damage to economic growth.John Butters - Chief Investment Officer

A brief market overview

Global stock markets edged up a little in the third quarter of 2020. Overseas stocks were up about 4% and UK stocks were down by a similar amount. Gilts fell slightly. Looking at the year to date, global stock markets and bonds have put in positive, single-digit returns while the UK market remains a significant laggard, down about 20%.

US changes approach to inflation

The US Federal Reserve changed its inflation-targeting system in the quarter. First, it will no longer raise rates just because unemployment is low; second, if inflation falls below its 2% target for a period of time, the Fed will allow higher inflation afterwards to allow the price level to catch up. Similar changes could potentially happen here in the future.  Some might see this as a loss of discipline. Allow me to put a different case…

How was inflation controlled historically?

Under the old gold standard inflation had to be followed by deflation, which kept prices under control at the cost of periodic depressions. Since the early 20th century society has been learning how to control inflation without that cost. After World War II, major currencies were pegged to the US dollar and the dollar pegged to gold. This allowed some flexibility because currencies could be ‘devalued’ in a crisis, creating inflation but smoothing fluctuations in growth. Governments also tried legal price controls, which did not work. In the 1970s the system broke down, allowing inflation to rise. In response, in the early 1980s, the idea of controlling the money supply was tried. That put an end to high inflation, but the money supply was hard to control, so the idea evolved through the 1980s of preventing inflation by changing interest rates, and this was formalised around the world in the 1990s.

Looking forward

In the new century we have discovered a problem: there is no reliable way of increasing inflation when it is below target, which brings back the old risk of deflation, hence the various experiments of recent years, including the changes in this quarter. We cannot of course be certain that inflation will stay under control. But it can be argued, more reassuringly, that these changes are just the latest chapter in a long effort to control inflation without doing too much damage to economic growth.

John Butters, Chief Investment Officer

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Important information

The information contained in this article does not constitute financial advice or a personal recommendation.  Past performance is not a guide to future performance. The value of an investment and its income can both increase and decrease and you may not get back the full amount originally invested. The value of overseas investments will be influenced by the rate of exchange.

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