Thursday 18 March 2010

Inflation at 4% to be the New Normal?

Cynics might say it is a conspiracy to prepare the ground for higher inflation to be accepted by central banks. Realists will observe and weigh the probability that it will happen and think how to protect themselves or profit from the eventuality. Whatever one's attitude it is worth noting recent comments and facts on the subject.

Chief economist at the International Monetary Fund Olivier Blanchard published a paper in February advocating a higher inflation target of 4%, which idea influential US economist Paul Krugman praised in the NY Times, citing other economists who have proposed the same. A UK news article in the Independent then discusses the idea, saying the old targets of 2% may have been fine in the past but not for the future.

Meanwhile, the most recent actual UK inflation rate was 3.5% and the National Posts reports that the World Bank forecasts that inflation worldwide will be 3.7% this year and that a rate of 4-5% in emerging markets is not a problem. Canada's inflation rate was only 1.9% in the latest January figures. That's nice and right in the middle of the official target range of 1 to 3%. However, it might be good to keep in mind one of Wayne Gretzky's secrets of success, the advice from his dad Walter to "skate where the puck's going, not where it's been".

Of course, not everyone agrees that 4% would be a good thing, but who listens to blogger Mike Moffatt when a Nobel Laureate like Krugman speaks? The fact that higher inflation would reduce the real value of the huge amounts of public debt taken on to recapitalize banks and to stimulate the economy conveniently enhances the acceptability of the idea to governments.

So, what are some of the investments to counter or profit from higher inflation?
  • Real return bonds - the best and surest: best, because it offers an automatically-adjusted positive return over and above CPI and; surest, because it has the guarantee of the government (which admittedly is not an absolute but it is better than anyone else's). Note that in Canada, if RRBs are held in a taxable account, the government taxes all of the return, including the nominal increase to adjust for inflation. The higher the inflation and the higher the tax bracket, the more taxes to pay. That can result in a net after-tax loss relative to inflation (e.g. 4% inflation + 1.5% real return less 40% tax = 3.3% net after-tax). RRBs are most effective in a registered, tax-protected account.
  • Equities - when inflation is higher but steady - businesses can and do adjust their prices; not so good to deal with unexpected inflation and big erratic jumps, like the 1970s. This scenario seems to be more the case now with the talk of new inflation-targeting of 4%.
  • Gold - probably best for unexpected hyperinflation or crisis scenarios and not for steady, expected high(er) inflation like a 4% target that is maintained and adhered to
Update April 1: the Globe and Mail reports that a Bank of Canada deputy governor doesn't like the IMF idea. Good on him! If most people were to be asked, if there was any change made to the inflation target it should be downwards to 0%, in other words price stability.


larry macdonald said...

The people who adocate 4% inflation really should read up on money illusion. Once the inflation genie is out of the lamp, it's hard to put him back in. If 2% gave us asset bubbles that nearly wiped out the global financial system, imagine what 4% would do.

CanadianInvestor said...

Cannot but agree, it took 20 years to tame inflation last time (1970s to mid 90s). Once that ball gets rolling, it's hard to stop.

Anonymous said...

Cheap Money is something people without money want. Dear Money is what people without money want.

Old news before Franklin.


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