No matter which inflation gauge you use, U.S. price growth has decelerated sharply in the past year. Yet, now that the Federal Reserve has managed to bring inflation closer to its 2% target, it could be a mistake to think it will stay low.
To the contrary, inflation is likely to be a more persistent threat than it has been in decades, owing to the long list of powerful forces that have driven prices higher, and the limits of central-bank efforts to control it. History also suggests that price volatility is less the exception than the norm.
“Anyone who’s younger than 50 and hasn’t lived in an emerging market has had no real experience of inflation,” says Stephen D. King, a former chief economist at HSBC in London, and author of the book We Need to Talk About Inflation, published in May by Yale University Press. “One of the lessons of the 1970s is that if inflation starts to head down and you become relaxed, before you know it, it ratchets higher again. You could go from 5% to 3%, then to 6% and 4%, and back to 7.5%. The fact that it comes down doesn’t mean it’s going to come down and stay down.”
No one would accuse Federal Reserve Chair Jerome Powell of relaxing in today’s inflation fight. But Powell and other central bankers know they can’t keep interest rates at a level that suppresses economic vitality long-term. To be sure, high rates would create low and stable inflation, but it would be the stability of the graveyard, which no one wants.
Last year’s inflationary spiral had multiple causes: massive government spending to offset a pandemic-related economic meltdown that never quite came, supply-chain snarls that interrupted the flow of goods, and the energy shock that followed Russia’s invasion of Ukraine. But longer term forces were also at work.
Demographics was one. After many years of workforce growth, the labor market had begun to thin out, putting upward pressure on wages. Climate change is also inflationary, reducing food supply, among other things. Olive oil prices have climbed to the highest levels on record after a protracted drought in Spain. Sugar prices are being pushed up by excess rain in India, and these are but two of many examples.
Fighting climate change also is costly, and will remain so. Low-carbon transition plans are necessary for future prosperity, but add to today’s expenses. Achieving a net-zero global economy by 2050 will require $9.2 trillion in annual investments — almost half the size of the U.S. economy, McKinsey estimates.
Add it all up, and it seems clear that a return to the low-inflation, ultralow-interest-rate world of recent years isn’t in the cards. “We’re moving from a world that was previously dominated by the abundance of resources to one that’s dominated by scarcity,” said Hugh Gimber, global market strategist at J.P. Morgan Asset Management in London. “The economic world could look quite different over the next five to 10 years. Using past performance as a guide to the future is something we always warn against, but it’s especially true now.”
The revival of inflation also puts investors in a different universe than the one they occupied for the past 30 years. This creates challenges and opportunities, and suggests the need for a more actively managed portfolio.
Traditionally gold and hard assets, such as real estate and commodities, were considered the best inflation hedges. Gold, at least, has a record as a store of value that stretches back thousands of years. Yet, the yellow metal doesn’t produce a revenue stream, and its price, too, is volatile. Physical assets might look attractive, but King notes that history shows their returns can also be poor in inflationary periods.
Strategists at
BlackRock,
the world’s biggest money manager, give inflation-linked bonds in developed markets their strongest strategic overweight, based on a view that most of the bond market still fails to appreciate how persistent inflation might prove. Beyond that, they recommend investing in trends with a long runway, such as artificial intelligence.
Another approach would be to look at sectors that didn’t do particularly well in a low-interest-rate world, in the hope they’ll do better if interest rates stay elevated. Banks, for example, tend to perform better when interest rates are higher because their net interest margins improve.
Most important, investors should recognize that inflation’s long slumber is over, notwithstanding some recent predictions that price deflation is looming. The average inflation rate over the course of a year topped 5% in 2022 for the first time since 1990. It is reasonable to assume it will happen again in the next few years.
Write to Brian Swint at [email protected]
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