What if 5% is the new 2%?

I’m just back from a terribly timed, but much needed, family holiday. At one lunch our bill came to 29,000. I passed it across to my sons and said, "goodness – you will need to pay for this". They looked at me in horror. Fortunately, we were in Argentina. Our bill was for 29,000 pesos, which equated to roughly £17.

As we ventured around Latin America there were numerous other opportunities to give my children a lesson in the importance of price stability (I promise I was also fun at times). Inflation was a continual topic of conversation with taxi drivers, for example.

It was clear that price rises were a daily worry, as well as the need to think about, and spend time sourcing, the cheapest goods which, on our trip, included crossing a border for petrol. The wad of notes needed to pay a small entry fee to a national park astounded us all. The social and economic costs of a high inflation regime were abundantly clear.

As I return to my desk, my trip brought home the risks presented should the US administration alter the US Federal Reserve’s ability to set monetary policy independently in order to maintain price stability. Since the pandemic I’ve been arguing that investors should probably consider 3% as the new 2% for ‘normal’ inflation. My view was that the pandemic structurally altered both the fabric of the global economy and the fiscal policy levers that influence demand.

The question I’m now asking myself is whether I’ve been too conservative. Could 5% be the new 2%? And if this level of inflation is a possibility, how should investors position themselves for the corrosive damage of continual price rises? I’ll offer some brief thoughts now, but this will be the question I return to in more detail next month.

Could inflation actually end up much higher on a sustained basis? Inflation will always get pushed around by cyclical factors. In the near-term the tariffs will most likely raise cost pressures for firms, in the US at least. Firms will try their best to push these cost pressures through to their end consumer, but whether they can will depend on whether demand holds up.

Even so, these price increases should be one-time effects. The medium-term problems come when the system becomes de-anchored. In other words, when everyone gets used to a higher number and so 5%, say, becomes the normal rule that firms abide by when setting their prices.

This is where the independence of a central bank with a clear mandate is essential. All actors in the economy – households and businesses – need to be aware of both the inflation target and the central bank’s commitment to it. A successfully anchored system is one in which everyone feels sufficiently fearful that if they try to push for a higher number – whether in the wages they ask for, or the prices they charge – they will be met with the wrath of the central bank, through higher interest rates, and falling demand and employment prospects.

The second that commitment is questioned; everyone becomes tempted to push their luck. That’s how higher inflation becomes embedded. There are already worrying signs that the US system is becoming de-anchored, with households starting to think that inflation is likely to be higher in both the short and medium term.    

We should be extolling the virtues of our independent central banks and the tough decisions they have to make to deliver price stability. A journey around Latin America is a reminder of what happens when price stability is taken for granted.

Investors in the meantime need to start thinking hard about the role of inflation in their portfolio. They need to think about real, not nominal returns, and what inflation does to the value of cash in bank accounts. They need to demand an appropriate yield from fixed income assets. And they need to look for assets that have some limits on supply, which tend to preserve their real value. I’ll be delving deeper into all these considerations soon. Stay tuned.

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