Why we need higher inflation over the next 5 years . . .
by Michael Davenport
London Grip’s economics editor takes stock
The IMF’s chief economist, Olivier Blanchard, and two of his staff have recently published a report* which argues in favour of raising the target inflation rates in the Europe and the US. The argument is that low rates of inflation limit the effectiveness of monetary policy as an instrument for dealing with recession or other shocks to the world economy. Interest rates cannot be reduced to below zero per cent – or slightly more – which implies that with an inflation rate of 2 per cent, the current official target in the Eurozone and the UK, and the implicit target in the US, real, i.e. inflation-adjusted, interest rates for prime short-term borrowers cannot be pushed below a negative 2 per cent. That may not be enough to deal with the problem.
But there is another argument why the target inflation rate needs to be raised, at least over the next few years. For electoral reasons, no government in the US, the Eurozone or the UK, is likely raise taxes sufficiently to bring the national debt down to an acceptable level, say to 50 per cent of GDP within five years. As a result social services and other expenditures will be severely cut, with unpredictable but damaging effects on families with children in education, on the unemployed, old and sick, on families in need and for those made redundant by local and central government.
The only way of protecting public services without a taxpayer revolt is through spreading the tax burden by allowing inflation to rise. For example, with inflation at 5 per cent and growth at 2 ½ per cent, a national debt relative to GDP of 80 per cent would be reduced to 60 per cent in five years. Clearly nominal tax increases are also needed because retaining the higher inflation target beyond that period could have increasingly negative implications for a country’s bond market. It would be disastrous if inflation expectations got out of hand and interest rates had to rise sharply. We could all go the way of Greece. But a 5 per cent inflation target, closely monitored by an independent and committed central bank, would prevent that. The credibility of the Federal Reserve, the European Central Bank and the Bank of England’s inflation targeting is high as is shown by expected inflation rates, both those implicit in the bond markets and those in surveys.
Such a policy would effectively spread the burden of the debt among all taxpayers. The most vulnerable groups – such as pensioners and families dependent on benefits – can be protected through indexation (and the indexes used can actually reflect the patterns of expenditure of those groups, not simply the consumer price index). True, there would be some increase in government bond rates. But in the UK, for example, where the average gilt maturity is 14 years and average nominal interest rate about 4 per cent, with inflation at 5 per cent over five years, the average interest rate on new issues over that period would rise by only some 0.5 per cent.
Of course people with existing savings would suffer to the extent that interest rates did not keep up with inflation but again the losses would be limited. At the end of the five years prices would be some 7 per cent higher but higher interest rates over the five years would reduce the real loss to about 5 per cent.
Thus there would be significant gains from formally adopting a higher target inflation rate: a reinforced monetary policy, maybe needed to counter any second recessionary dip, and governments would be more likely to formally adopt measures to protect pensioners and recipients of social security payments from loss in their real incomes. However many people would argue that inflation is due to rise in any event – whether the target rate is raised or not. Governments are keen to see a fall in the real cost of servicing the national debt and in the absolute value of that debt and will not be sufficiently austere with their fiscal policy. Meanwhile the central banks will not be able to sterilize the huge monetary stimuli of recent years without unacceptably high rates of interest. The UK monetary base has tripled since the start of quantitative easing and we have no experience in sterilising such an increase. Nor do the Americans or Eurozone countries. Moreover when growth resumes seriously in the developed world and that is added to the already high growth rates among the emerging countries, there will be new pressures on commodity prices. And the UK has the added inflationary impulse from a depreciating exchange rate.
It is clear that persuading the Eurozone countries, in particular Germany with its fetish about inflation, that a modest rise in target rates would be a good thing, is likely to be well-nigh impossible unless action were taken by the US and/or the UK first. Even in those two countries it will be difficult though a few economists are now arguing in favour, primarily to raise the effectiveness of monetary policy rather than to spread the burden of the increased debt more fairly. In any event, a sharp rise in inflation, whether planned or not, is likely – not immediately – but probably from next year onwards.
What does this imply for personal investment planning? How do we protect our precious savings against turning into worthless scraps of paper as inflation picks up? Firstly the prices of commodities, including oil and gas, metals and agricultural goods, are likely to be pulled up by the world recovery; indeed they are already benefitting from the sharp recoveries in China, India, Brazil and some of the smaller emerging nations. There are a number of Exchange Traded Funds (ETFs) which track different commodity indexes, from individual products such as wheat or aluminium to groups of such commodities. (ETFs are open-ended mutual funds that are different from unit trusts in that they are bought or sold throughout the trading day in the same way as an investment trust or ordinary company share. Some of the main providers are ETF Securities Limited, iShares and Lyxor. They are much cheaper to trade than managed unit trusts and carry no management charges.)
Secondly, because of the need for extraordinarily tough fiscal policy, growth prospects for the UK are poor relative to those in most European countries and, even more so, relative to the emerging countries. This suggests that equity investment should have a high overseas component. But given that there remains a real danger of a second recession dip – even in the BRICs (Brazil, Russia, India and China) – emphasis should be placed on a unit trust or investment trust that concentrates on defensive shares with a strong dividend record. “Defensive” means that the companies should be as recession-proof as possible – pharmaceuticals, supermarkets, tobacco (unless you have moral qualms) etc. There are unit trusts that meet these requirements. Invesco Perpetual Global Equity is one which I hold.
Finally corporate bonds have done very well over the last few years. In late 2008 they were greatly depressed by the huge loss of confidence that followed the collapse of Lehmann Brothers and general panic about the solvency of financial institutions across the world. But in fact, as regards the non-financial sectors, that panic was overdone. Even now they are largely undervalued, in particular those with short-term maturities. The values of longer term bonds – those with more than five years to run – will be hurt by the upcoming inflation and rising yields on government bonds necessitated by higher volumes of new issues. Buying short-dated high quality corporate bond funds with a good spread of European, US and emerging market companies, is likely to remain a low-risk means of limiting portfolio risk over the next couple of years. But as soon as inflation starts rising significantly – maybe towards the end of next year – such holdings should be liquidated.
Michael Davenport, 23 March 2010
* Olivier Blanchard, Giovanni Dell’Ariccia, and Paolo Mauro, Rethinking Macroeconomic Policy, IMF: Washington, February 2010
Michael Davenport has taught economics at the University of York, worked in the Treasury (U.K.) and with the European Commission, and as a consultant to developing countries in the arts of trade policy and negotiation.