Download COVID-19 Inflation White Paper
The COVID-19 pandemic is not only significantly impacting our lives now but may continue to do so for a long time. The purpose of this white paper is to discuss its potential impact on inflation and what this might mean for personal finances. Governments are currently shouldering the major cost of COVID-19, but it may be ordinary people who bear the long-term burden, if inflation then takes off.
It is likely that inflation will decline in the coming year to 0-1% due to decreasing demand and the effects of declining commodity prices. However, as the world recovers after a COVID-19 vaccine has been found, inflation may well push higher above the 2% target and remain in the 3-5% range for the rest of the decade.
The UK government is likely to allow inflation to rise and will use it as a form of ‘inflation tax’. Historically, governments have not paid back borrowing created in national emergencies. Instead they have used inflation to reduce the value of a country’s debts in real terms and to make interest repayments more affordable. They are also likely to hold base rates near zero for a long time to help reduce those payments.
This scenario would have a number of implications for private investors:
- The ‘inflation tax’ would target bonds resulting in negligible returns and a loss after inflation. Index-linked bonds appear to be no solution as they are currently overpriced and face a re-rating risk should the government switch their linking from RPI to CPIH. In addition, all bonds have an additional risk of capital loss when interest rates finally rise.
- The purchasing power of cash savings would also be eroded by this potential ‘inflation tax’. For example, just six years of 5% inflation and near zero interest rates would reduce the value of cash by a quarter.
- Shares may be a safer haven. Historically they have returned a theoretical (excluding costs) ~5% pa above inflation, but such levels seem unlikely in the coming decade. In the short-term, returns from shares may be lower due to companies needing to repair balance sheets and invest in redesigning their businesses for a post COVID-19 world. Longer-term, should inflation reach 4-5%, real returns from shares could be halved in the past.
- Precious metals are the only asset class to normally outperform during periods of higher inflation – particularly if rates get above 4-5% and towards 10%.
- Alternative investments offering potentially higher apparent rates of return, such as peer-to-peer lending and cryptocurrencies, have significant risks of capital losses.
- House prices could rise but are unlikely to keep up with higher inflation rates. However, mortgage rates may well remain low.
- Wages might not keep pace with higher inflation rates leading to a gradual erosion of average standards of living.
- Returns from pensions would be negatively affected by ‘inflation tax’. Those still saving will be impacted by the lower bond returns. Those retiring now will get low annuity rates. The pensions of those already retired are unlikely to keep pace with true inflation rates.
Over the longer-term, history shows that inflation follows a wave-like pattern – rising for periods of up to 140 years, before a major event causes it to stop. In the current context, such an event could be rising interest rates. Prices might then decline sharply as world debts are finally restructured. Managing finances in such a transitionary period, if it were to occur, would be difficult. The latest inflation wave has just 16 years to go before it reaches its end-of-cycle maximum.Download COVID-19 Inflation White Paper