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Writer's pictureVictoria Hayes

Under the Hat: 'Flation. Which sort and does it matter?



One of the many “known unknowns” circulating the planet is the direction, magnitude and longevity of inflation. Another known unknown is the definition of transitory. Put the two together and you have the makings of stagflation as global GDP appears to be on the wane. No recession in sight in the US (although the latest UK GDP print came in at 0.1%), but a definite slowing of activity.


We have not seen significant inflation since the late 70s and early 80s and when I say “we” there aren’t that many of us who have experienced high double- digit numbers. The interesting thing about inflation, that not many people know about, is that expectations drive the outcome.


Currently you can’t read a corporate quarterly report without some mention of rising prices or wages or both. The CEO of Maersk, the Danish shipping company, has said that the only way for the supply chain issue to be resolved is to find a way to reduce demand. Best of luck with that strategy. If buyers think that prices are going to go up, then they will buy now when goods are “cheap”; the opposite to a deflationary scenario where consumers hoard cash looking to buy at cheaper prices later. Thus, we enter the inflationary spiral. Higher prices beget higher demand which leads to higher prices.



Were growth to slow significantly, which would only happen if governments and central banks took away their fiscal and monetary punchbowls, an unlikely happening we would surmise, then inflation would subside. Longer term demographics also suggest that we are more likely to be moving towards a deflationary environment.


Deflation is the virus that central banks want to avoid like the plague. The time-honoured mechanism for reducing the debt burden is to let inflation rip which means that real interest rates fall dramatically making the servicing and repayment of debt that much cheaper. The Fed have said that they are willing to tolerate higher inflation. They don’t really have a choice. They can’t put interest rates up to cap it off as Volker did 40 years ago so they let inflation rise and let the currency take the strain.


In the short term that’s good for equities and real assets like gold, and more basic commodities (copper, iron ore, aluminium, uranium) but letting the proverbial out of the bottle is dangerous move. A more effective strategy would be for the Fed to keep short term interest rates down but let the long end of the bond market curve (10 years plus) rise to market clearing levels which in the short term might be in the 3-4% region.


This would allow the government to keep borrowing at low short- term rates, crucial given the debt servicing costs at higher rates, and send a message to more leveraged parts of the economy notably the housing and stock markets. They will still be able to supply liquidity to markets as they start to reduce their balance sheet using the rejuvenated standing repo facility (SRF) which is effectively QE by other means.


Higher rates would also send a message to the corporate sector to prioritise profitable ventures and cut down on share buy backs. With borrowing rates near zero, CEOs have little incentive to take risks and share buybacks add nothing to GDP. A significant rise in GDP growth would also get the bankers out of jail, but the levels required, double digits for the next 10 years, are not exactly realistic.

So it looks like inflation and a weak dollar, which will be good for quality equities (think big tech and strong balance sheet companies in emerging markets especially those with oil and mineral exposure), commodities and real assets. Short- dated bonds will be a “safe haven” but long duration will be the easiest way to lose money.

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