The outlook for inflation

This article is part of
Guide to defensive multi-asset investing

The outlook for inflation

Perhaps the most important question facing asset allocators in the coming years is the outlook for inflation.

All economies have a natural, or trend, rate of growth, when the actual rate is above this, then inflation will occur, while growth below this level keeps inflation low.

The distance between the natural level of growth and the level being achieved at any one time is known as the output gap. 

Andy Haldane, chief economist at the Bank of England has stated that the UK’s trend rate of economic growth is 1.5 per cent.

Source: ONS

A steep reduction in demand such as is being caused by the Coronavirus, will lead to negative economic growth in the UK in the coming months.

The difference between that negative number and 1.5 per cent is the output gap in the economy.

Impact on inflation

Such a severe gap between the level at which the economy can operate and the level at which it is operating, means inflation will be very low, and may not, in the short-term, be something with which advisers need to concern themselves.

The vast suite of economic policy measures announced by chancellor Rishi Sunak and the Bank of England are designed to lift economic growth and narrow the output gap.

The more the gap narrows, the more likely there is to be inflation in the economy.

Policymakers' response to the global financial crisis was driven by central banks injecting cash into the system, known as quantitative easing, while governments operated with comparatively modest budget deficits. 

The outcome was that economic growth was relatively modest in the decade immediately after the financial crisis, while inflation also stayed low, and generally below the central bank’s target of 2 per cent.

Low inflation generally helps the investment case for bonds, as low inflation makes the income paid to bond holders worth relatively more, and also those shares which generate a steady, consistent income. 

The policy response to the Covid 19 crisis differs from that deployed after the financial crisis in that government spending has been added to the method used then.

Paul Flood, multi-asset manager at BNY Mellon says: “If one had looked at the textbooks, then the policies used by the central banks after the financial crisis should have been inflationary, but that didn’t happen because the extra cash that went into the system did not really find its way into the real economy, so growth was not as high as it could have been and nor was inflation.

"But the response to this crisis, they have done what was asked of them, with the government also increasing spending, and that is much more likely to find its way into the real economy, and so to be inflationary. 

The challenge for policymakers is that the extra stimulus pumped into the economy closes the output gap quickly, and then interest rates are too low, and the government deficit too high, for the prevailing economic conditions, and inflation rises quickly.