Weekly outlook

So which way are prices heading?

By Tom Stevenson, 4 February 2009

Why investors need to decide whether to worry about inflation or deflation

A year ago everyone was worried about inflation. Six months ago, deflation fears gained the upper hand. Today both cases are made with equal force. Given that investors would choose to tilt their portfolios into quite different assets for each scenario, it matters a great deal who is right here. So what are the arguments either way? This week the Bank of England’s monetary policy committee will decide whether to cut interest rates from their existing record low of 1.5% to 1% or even lower. If it does cut, it will be in part because the deflationists are in the driving seat again. The widespread fear in the early part of 2008 that soaring oil and food prices would feed through into a generalised wage-price spiral will have been comprehensively discredited by a deepening global recession.

"Politicians are much more likely to overdo it" Tom Stevenson

Concerns over deflation continue to mount, with the rates of inflation in the US (0.1%) and Europe (1.6%) down considerably from their summer peaks of 5.5% and 4.0% respectively. Inflation expectations have tumbled and the prices at which inflation-linked bonds are trading in the markets makes sense only if you believe that inflation in America will average less than 0.5% a year for the next 10 years.

Those that argue we are entering a period of prolonged falling prices point to the deepest recession since the Great Depression, the ongoing freefall in the world’s most overvalued housing markets and the continuing severe contraction in credit. Until company profitability normalises, house prices stabilise and banks start lending again inflation cannot be a problem again.

Moreover, the deflationists say that we shouldn’t worry about inflation until economic growth has narrowed the gap between actual output and the output the economy is capable of generating in normal circumstances – what economists call the “output gap”. While there is still slack in the market, the inflationary dragon won’t stir again, they argue.

Another part of the deflationists’ case is that although governments are doing all they can to fend off falling prices, their measures (extreme as they are) may not have the desired effect as long as individuals choose not to spend and borrow and banks prefer not to lend.

Storing up trouble 

On the other side of the debate, the inflationists argue, first, that the massive scale of the government interventions in train or being discussed is storing up inflation problems down the track. Because the bail-outs and stimuli being put in place are essentially un-calibrated, no-one really knows how much money needs to be thrown at the problem. If in doubt, politicians are much more likely to err on the side of overdoing it than risk being accused of not doing enough.

It is much easier for a government to announce a spending package or a tax cut than it is to get agreement on how it should be funded, or indeed to unwind the stimulus when it has done its job and before it has started to become counter-productive. Democracies and tough decisions do not always go hand in hand.

Inflationists also argue that the globalisation of the past 20 years or so has effectively disguised the real underlying rate of price appreciation in many countries. In Britain, for example, we have got used to the cost of many services rising quite fast even while the cost of imported goods such as electronics and clothes has fallen.

Moreover, if the protectionist urges finding voice today become entrenched then we might have to get used to the higher costs that British Jobs for British Workers imply. As they say: be careful what you wish for.

It is, therefore, entirely possible that prices could rise despite an absence of economic growth and not, as the deflationists argue, only after growth has resumed. There is an extreme example of this in the world today in Zimbabwe, although no-one is seriously suggesting just yet that the rest of the world is heading that way.

Why investors should care 

This debate might seem a bit sterile and academic but it is important to investors for two reasons. First, because the rate of inflation or deflation has historically had a significant bearing on the price investors are prepared to pay for shares – both deflation and high inflation have been associated with low valuations for stocks while the highest price/earnings multiples are achieved when inflation is low and stable.

Second, the inflation or deflation outlook has implications for which asset classes are likely to do well. In simple terms, if you believe the deflationists you want to own lots of government bonds and cash and if you favour the inflationists’ arguments you will prefer to own commodities and also equities and property.

Of course, no-one will know who is right until after the event, so for most investors the safest approach is to spread their assets widely, perhaps via a balanced or multi-asset fund. And, with all this uncertainty, there’s a good argument for having a little bit of gold tucked away too – it’s probably the only investment asset which some experts think could offer a hedge against soaring prices or a safe haven during the financial instability that full-blown deflation might trigger.