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3 ways inflation could make a return

We take a closer look at three potential ways inflation could make a return and what it could mean for investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

William Ryder
Equity Analyst

Published on 7 April 2021

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

We’ve written before about the potential for inflation in the coming years, and a lively debate is running among economists and investors.

Is inflation on the horizon?

Inflation is the overall rise in prices in the economy, and we still don’t have a unanimous consensus about what causes it. Economists and commentators often have different models of inflation in mind and end up talking past each other.

In this article we look at some of the potential paths inflation could take, and consider what they could mean for investors.

This article isn’t personal advice. If you’re not sure if an investment or course of action is right for you, seek financial advice.

A short sharp shock

Lots of people have suffered serious financial hardship over the last year, despite the various government support schemes. However, many other people have actually seen their household finances improve.

People have been spending less on restaurants, holidays, commuting and general impulse shopping. Collectively Brits have paid off over £17bn in credit card debt since February 2020.

UK Credit Card Debt (£bn)

Source: Bank of England, 31/03/2021.

Collectively we might have quite a lot of money to buy stuff with as society reopens, but there might not be enough stuff to buy. This could result in rising prices if demand outstrips supply, but it’s unlikely to be sustained. Soon we're likely to have spent all the money we’ve saved and prices should stabilise.

Frankly, we think a short burst of inflation isn’t something investors should worry too much about. The market could get jittery but, if this scenario plays out, conditions should go back to normal fairly quickly. That is, unless we get a wage-price spiral.

Wage-price spiral

Imagine it’s Monday 3 January 2022 and inflation over the last year was 4.6%. You go for your annual performance review with your boss and ask for a pay rise as prices are up and you think they’ll keep rising. So, you ask for a slightly above inflation increase just to avoid falling behind. After all, your parents’ pensions rise automatically with inflation thanks to the triple lock.

Fortunately, your employer grants the request. They saw this coming and had already raised their prices to cover rising wage expenses. Unfortunately, everyone else did the same.

A short spike in inflation could potentially provoke this type of spiral. It’s the kind of inflation that could be exacerbated by too much government spending as this could also increase the amount of demand in the economy.

Lots of central banks have said they’ll tolerate a bit of inflation in the short term, but we think they’re unlikely to do so for very long.

Once central banks decide they’ve had enough they’ll raise interest rates, hopefully putting a lid on inflation at the likely cost of slowing growth.

Investors could position themselves for this type of inflation by investing in assets that are likely to hold their value through both inflation and higher interest rates. Commodities, and precious metals in particular, have been good inflation hedges historically and provided some shelter.

Companies with strong pricing power are also more likely to be able to raise prices to help compensate for inflation. So it could be a good idea to look for companies with strong profit margins or steady demand, like regulated utilities. Inflation-linked bonds also offer some inbuilt shelter from inflation.

Remember, just because some investments might have done well in similar circumstances before doesn’t mean it’ll happen again. They (or the income they produce) could fall in value and investors could make a loss.

Fiscal Inflation

Fiscal theories of inflation are not mainstream and tend to come from economists that habitually worry about governments spending more than they’re bringing in through taxes.

The argument goes like this: if governments don’t bring in enough taxes to pay for their spending, they usually just borrow more. But there will come a point, and we don’t know where this point is, when markets lose faith in the government’s ability to ever repay its debts – and they stop lending the government money.

UK Net Debt to GDP Ratio

Scroll across to see the full chart.

Source: ONS, 31/03/2021.

The government would then have two choices:

Default on the debt. Governments will almost never do this, especially when they can…
Print more money.

What could this look like in reality?

Well, debt crises are like bankruptcies – they happen gradually, then suddenly. If investors lose faith in the government, they’ll expect the printing presses to start rolling. The more money in circulation, the less valuable it becomes – so they’ll try to get rid of their cash pre-emptively.

Government interest rates would rise suddenly (as investors stop lending), foreign exchange rates would collapse suddenly (as investors try to ditch the local currency) and inflation would rise suddenly and surprisingly.

They key point is that all of this could happen quickly and without warning. No one wants to get stuck holding the bag, so as soon as some investors start running for the exits others may rush to follow.

This sort of panic is inherently unpredictable and would be very difficult for central banks to control. In this scenario, interest rates have already risen – so central banks can’t simply hike rates to control prices.

It would be wrong to ‘predict’ this kind of inflation – instead it should be thought of as a risk, like the risk of a war or another pandemic. The level of risk can be high or low, or rising or falling. Supporters of fiscal theory would argue that the massive increase in government debt during the pandemic has raised the risk of this kind of inflation.

This is a much more challenging scenario for investors to prepare for, as it essentially involves a government default. As scary as that might sound, it isn’t a mainstream economic view and even then, it’s only one of a number of potential risks investors need to consider.

These sorts of risks are best addressed through careful consideration of your own risk preferences and diversification. As with a wage-price spiral, commodities, precious metals, and companies that could raise prices and potentially offer shelter are some areas you could consider.

Remember though, inflation might not take off at all. If you distort your portfolio too much, you could lose out if prices remain stable. Diversification is key.

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