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Inflation Update

The inflation debate: Will Covid-19 trigger higher inflation?

Staying in cash can have a serious effect on your wealth. Inflation erodes the real value of your money over time and while inflation has remained subdued for almost three decades, Covid-19 has ignited the debate on whether the pandemic-induced financial measures will result in a sustained period of higher inflation. John Butters, Chief Investment Officer, talks to Paul Dales, Chief Economist at Capital Economics, to get his views on the outlook for inflation in a post-pandemic world.

Key talking points  

  • deflation a bigger risk in the short term
  • risk central banks tolerate inflation higher than 2%
  • inflation emerges as a greater risk once economies return to normal
  • sitting in cash is an inflation risk – don’t under-invest in equities
  • portfolio diversification the key

Why does inflation matter for investors?

Inflation erodes the real value of money and seemingly small differences in inflation can have a big influence over time. Inflation at just 2% each year over a 30-year period reduces the purchasing power of £100 by 30%. The coronavirus crisis has made the outlook for inflation more uncertain than for the past decade, if not the past 30 years – and so it’s important to think about how the crisis could influence inflation and highlight the risks.

What can we learn from history?

First, inflation has historically swung around widely. A lot of that was due to the business cycle being dominated by harvests, wars and pandemics many years ago, at least some of which don’t apply today. Even so, the stability of the past few decades looks like the aberration rather than the norm.

Second, before World War I, it was almost as common for inflation to be below zero as it was for it to be above it. Indeed, deflation (falling prices) is more normal than you may think. Third, there have been periods in which inflation has been sustained at very high levels. That was the case after World War I and also in the 1970s and early 1980s after the oil price shocks and when policy was too loose for too long.

There is a difference today. Globalisation, led by China, has helped keep a lid on prices, while many central banks are now independent from governments, which gives an added layer of control over keeping inflation in check.

What do we need to think about when it comes to the future?

The pandemic has made the outlook for inflation very uncertain. The risk of a deflation scenario is greatest over the next five years. That’s because the collapse in output has left a lot of spare capacity, which tends to weigh on inflation. For instance, think what it means for workers – if there are many other people who are willing and able to do your job, then it’s unlikely that you’ll be able to negotiate a higher wage. If wages aren’t rising as fast, then businesses don’t need to increase their prices as quickly. That’s one way in which spare capacity tends to reduce inflation.

Is this the start of a long period of widespread deflation?

Probably not. Deflation in the UK has so far been confined to a small number of items and is not widespread among consumer prices or other parts of the economy. So we don’t think a prolonged period of deflation is inevitable or even probable.

Could the huge policy response from the government and the central bank trigger higher inflation?

This is a risk that is probably greatest for the decade after the next five years. The government’s fiscal spending and the Bank of England’s quantitative easing (QE) both inject more money into the economy in the hope that it boosts demand. And this morning the Bank announced another £150bn of QE. At the moment, these policies are best thought of as filling in the hole in demand caused by the Covid-19 recession. But when that hole is filled, if these policies continue to boost demand, they will generate inflation.

What’s different today compared to the QE in the aftermath of the 2008 Financial Crisis?

The Bank’s QE got stuck in the financial system and didn’t really make much of a difference to households and businesses. But this time it is different as the stimulus is finding its way into the hands of those who are most likely to spend it – households and businesses – and they are holding more in their bank accounts today. This could lead to a moderate rise in inflation of say between 3% and 5% at most.

So, inflation of 5% is the highest we can expect?

Not necessarily. There is another factor that could open the door to much higher rates of inflation. That’s because when the central bank and government work together in such a way, there’s a huge political incentive for it to continue. Put simply, the government is increasing spending and the Bank of England is financing it by using QE to print money, which keeps down the government’s borrowing costs. This is the kind of thing that governments can get addicted to and, if the central bank is willing to oblige, the money supply just keeps on getting bigger and bigger and inflation gets higher and higher. These are the root causes of hyperinflation, experienced in 1923 in Weimar Germany and more recently in Zimbabwe, where the IMF estimates inflation this year will be over 600%.

Surely the UK won’t go down the hyperinflation path?

These are very extreme examples and the UK’s institutional set-up is very different. As and when the economy is back to normal and all the spare capacity has been used up, policymakers could just withdraw the stimulus and prevent inflation from taking hold. Hyperinflation is a political phenomenon and it’s worth remembering that the Bank of England is independent, so it can always step in to prevent it. The Bank could reverse QE and raise interest rates, while the government could also reverse the loosening in fiscal policy by raising taxes and cutting spending.

Do you think the Bank of England will abandon the 2% inflation target?

Over the past 30 years, most major central banks have been wedded to their inflation targets. But there are three reasons why they might accommodate inflation that is a little higher. First, it could help the economy out of its recent bind by reducing real interest rates. Second, it would allow central banks to more easily take into account other issues, such as financial stability, which might help prevent a repeat of the financial crisis. Third, an unexpected bout of inflation would help to erode the recent rise in the government’s debt burden.

There are already some signs that central banks are starting to think this way. For example, in August, the Bank of England said that it would not tighten policy until inflation had actually risen to the 2% target whereas usually it tightens policy before inflation rises to 2%. But our hunch is that the UK government is wedded more closely to the 2% inflation target than, say, the US government.

You’ve talked about the risk of deflation and inflation. What do you actually expect to happen?

There is a short-term risk of inflation rising to around 3% in the event of a no-deal Brexit – the pound would likely weaken, which would push up the cost of importing products from overseas. But the most likely scenario is that over the next 20 years inflation will stay fairly close to the 2% target. Over the next five years, inflation risks are skewed to the downside due to the large amounts of spare capacity generated by the Covid-19 recession.

Beyond the next five years, the risk is in inflation rising above 2%. That’s because there is a danger than once the economy is back to normal and all the spare capacity has been used up, policymakers will either be too slow to remove the stimulus or will decide they don’t want to. That’s when the risk of a period of higher inflation is greatest.

Our view

Talk of hyperinflation in the Weimar Republic conjures up images of schoolboys flying kites made of banknotes, but there is no need to panic about the prospect of sky-high triple-digit inflation. Hyperinflation is not a serious risk, but you need to keep inflation in mind because even at modest levels inflation will reduce the value of your wealth over time – unless you have plans in place to mitigate its impact.
Given the sheer size of the pandemic-induced financial packages, there is a real prospect that governments around the world will tolerate slightly higher inflation of around 3–5% in the years ahead, rather than their current 2% target. They may be wary of introducing inflation-beating policies that could send economies trying to recover in the aftermath of the pandemic into reverse. A sum of £100,000 left in cash would be worth just £35,849 if inflation were 5% over a 20-year time period.
Interest rates are set to stay low for a prolonged period of time as governments and central banks give economies more wriggle room to recover in the wake of the pandemic. This is a real predicament for savers. Rates on savings accounts barely keep pace with inflation, which means that savers looking to preserve the purchasing power of their money will need to look beyond cash.

There is no investment asset that reliably protects against inflation in the short term, but many studies highlight that equities, over the long term, tend to outpace inflation. However, it’s important to be aware that not all equities are the same, and depending on the environment, some stocks will fare better than others. Prices of high-quality bonds can rise during periods of deflation and so offer some protection against falling prices.

The overriding message is to stay diversified and balanced in your investment portfolio. And be prepared to take a step up the risk ladder by investing in equities because staying in the perceived safety of cash is a risk – even when inflation remains subdued.

How Weatherbys can help

If you don’t want to spend time creating and constantly updating your financial plans, then let us take care of everything for you. We can work out what you need at every stage of your life. We will help you structure your portfolio to allow for unpredictable market fluctuations. In addition, we will make sure investments maximise your use of tax-efficient structures.


John Butters

Chief Investment Officer

John Butters joined Weatherbys Private Bank in 2016 and leads the investment and financial planning team. Prior to joining Weatherbys he developed an investment service for Aspinalls Family Office. He has also worked as a portfolio manager at the multi-family office Sand Aire, where he managed several investment funds, and at a London hedge fund which inspired his book on macroeconomic analysis, Rational Macro. John holds the Chartered Financial Analyst, Chartered Alternative Investment Analyst and Certified Financial Risk Manager qualifications and is a Chartered Member of the Chartered Institute for Securities and Investment.

Quentin Marshall

Managing Director of Weatherbys Bank

Quentin joined Weatherbys Private Bank as Head of Private Banking in June 2015 from Coutts where he had been Head of Advisory within the investments team and deputy chairman of the Investment Strategy Committee, overseeing c. £30bn of assets. Prior to Coutts, Quentin worked for UBS for sixteen years, joining predecessor firm SG Warburg from university as an Investment Banker. During this time he spent four years advising the Republic of Indonesia during the Asian financial crisis. He also acted for some of the largest FTSE100 companies raising capital and working on mergers and acquisitions. He subsequently specialised in advising family owned companies, moving to UBS Wealth Management to help create the UBS Family Office Group.

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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