Investing for inflation

With interest rates falling, and political pressure to bail out those who have taken on mortgages beyond their means, inflation has once more become a risk.

A slower economy naturally leads to a need for a more inflationary policy. This, in itself, is not a huge threat as the shift in policy (lower interest rates, printing money etc.) is in proportion to the slowdown, and is therefore unlikely to lead to high inflation.

The problem is that we currently have an additional motive for inflationary policy. Inflation will, naturally, take house prices up along with everything else. This could easily lead to a more inflationary policy sustained for longer than the need to stabilise the economy. To see just how bad this could get, consider the amount of inflation necessary to bring the ratio of incomes to house prices to its long term historical norm.

The danger is greatest in the US, but recent promises by the government to help those with mortgages they cannot afford make things in the UK look risky. The independence of the Bank of England should prevent this, but this independence has yet to be tested under stress. Even aside from the fact that the chancellor sets the inflation target, it is quite likely that independence would be compromised by political pressure — Gordon Brown giveth and Gordon Brown taketh away.

So, assuming inflation is going to be a problem, so how can we dilute or hedge the risk of inflation?

• Investing in commodities, especially precious metals, is a popular choice. The problem is that long term returns are usually low. In addition much of the recent rise has been due to Chinese buying which could reverse if the global economy really slows.
• Index linked gilts are very safe, and offer a fixed real return, but at a very low rate.
• Equities are fundamentally inflation proof, but the short term impact of a rise in inflation can be very significantly negative.
• Property is an excellent inflation hedge, but it hardly looks like a safe bet under current circumstances.

Although these strategies are all good in the face of inflation per se, the problem is that the risk is of inflation and low growth or recession, the spectre of stagflation.

It does not look as though there is a better option than equities. As the risk arises from the possible need to reflate an economy in recessions (or heading towards recessions), more specifically defensive value shares are safest. The biggest risks are that these may fall out of favour if the economy performs better than expected, and many are high yield and therefore vulnerable if interest rates rise instead of falling.