Last week I described how inflation can blow our pension plans out of the water. The big problem is time. While we should welcome the increasing likelihood that we will enjoy a long retirement, this silver lining is surrounded by a menacing cloud. The downside of living longer is that even a relatively small increase in the rate of inflation can put a massive dent in our pension pots when it’s compounded over many years.
So, this week, I thought I should explore the reasons why inflation might be more of a problem in the years ahead. And to do that I’m going to have to get a bit technical, so bear with me. Let’s start with a couple of words that you may have been lucky enough to have avoided so far – fiscal dominance.
What this describes is a situation where a country’s debts and deficits are sufficiently high that monetary policy (the setting of interest rates by central banks) is no longer an effective tool for controlling inflation. In fact, when fiscal dominance really kicks in, you can find yourself in an uncomfortable place where keeping interest rates high actually makes inflation worse. This dilemma keeps central bankers up at night. And it explains the fractious relationship between President Trump – who wants low interest rates to boost growth and make tax cuts affordable – and Fed chair Jerome Powell – who thinks his job is to keep prices in check.
Raising interest rates is a powerful tool for curtailing one type of the money creation that fuels inflation. Higher rates are good at restricting bank credit, which is one way of cooling an economy and reducing inflation. But they are much less effective when it comes to navigating fiscal deficits, which are the source of inflation which, in the wake of the US’s recently passed One Big Beautiful Bill, we need to worry about today.
The reason higher interest rates don’t work so well when public sector spending is driving inflation is that they make it more expensive for governments to finance their borrowing. They have to issue more bonds to pay the higher cost of servicing their debts, triggering the need for yet more inflationary money printing. Higher interest rates might look like the solution, but they can turn out to be the problem.
At various times, to counter this paradox, central banks have become subservient to governments, backing away from their central goal of containing inflation to instead facilitate public spending. Sometimes there is a good reason for this, and the problem goes away in due course. The suppression of interest rates during and after the second world war was resolved when fiscal discipline reasserted itself in peacetime. At other times, financial repression was less successful – the inflation that resulted from the ‘guns and butter’ spending on social programs and the Vietnam War was an example of fiscal dominance ending badly.
The Big Beautiful Bill is a regressive piece of fiscal legislation that transfers money from the poor to the wealthy, but that’s not its worst aspect. What’s really bad about this tax splurge is that there simply isn’t enough discretionary government spending to cut, even if you decide that this is a morally acceptable way to pay for the fiscal breaks. More than 60% of US government spending is mandatory, about 13% goes in interest payments, and half the remaining 25% or so is earmarked for defence.
So, the only way to square the circle is to undermine the independence of the Federal Reserve, to strong arm the central bank into cutting interest rates lower than they should be and to engage in Japanese-style yield curve control. That means setting a cap for bond yields and getting the Fed to buy back bonds to ensure it is not breached. All of this is inflationary.
If you’ve got this far, well done. It’s geeky stuff, and not something that I’d want to make my Mastermind subject. What it does tell me, however, is that in the years ahead, when I’m unlikely to be earning what I have been, and when I won’t be in receipt of a nice index-linked final salary pension, I will need to think hard about how to protect my savings from the ravages of inflation.
I’m old enough to remember the 1970s, which is starting to look like an increasingly useful template for investors. Now, as then, I expect the following to be sensible building blocks for an inflation-ready portfolio.
First, unless inflation really spirals out of control, I would expect the equity market to continue to provide the core of my investments. At very high levels of inflation, the stock market’s valuation can be pummelled, but at more moderate levels it is the place to be. Shares in high-quality companies with pricing power are the sweet spot. Given that the currency market is another pressure valve in an inflationary environment, I will also want to be well diversified geographically. A persistent decline in the value of the dollar would magnify the impact of any correction in the value of the US stock market.
Other investments that performed relatively well in the inflationary 1970s were real assets such as property, commodities and commodity producers, and neutral reserve assets such as gold. The precious metal and its digital counterpart Bitcoin have been telling us something important for a while now. They are pointing to a post-Powell world of fiscal dominance, lower interest rates and yield curve control, once the Fed chair’s term ends next May. Now feels like a good time to prepare for that.
This article originally appeared in The Telegraph