The failure to quell it quickly will transform financial markets
than two years since high inflation returned to the rich world, and hopes that it will quietly fade are themselves fading. True, prices are rising more slowly than in 2022, when the pace hit 9.1% in America, 10.6% in the euro area and 10.4% globally. But the view that this was just a passing lurch looks ever less plausible. Britain’s rate has been stuck at 8.7% for two months. American “core” prices, which exclude volatile food and energy, are 5.
The likelihood of monetary guardians explicitly admitting that they will tolerate inflation above 2% is low. Every time Jerome Powell, the chairman of the Federal Reserve, is asked about the possibility, he vehemently denies it. Such a shift, especially with prices already rising much faster than 2%, would immediately damage the Fed’s credibility: if the target can be ignored once, why not again?
But the erosion of the value of both the principal and the fixed interest payments is not the only way that higher inflation affects investments in bonds. Rising prices fuel expectations that central banks will raise rates, which in turn pushes yields in the bond market up to match those expectations. Bond prices are an inverse function of yields: when yields rise, prices fall.
On the face of things, shares are ideally suited to weathering spells of high inflation. They derive their value from the underlying companies’ earnings, and if prices are rising across the economy then those earnings, in aggregate, ought to be rising as well. Suppose inflation stays elevated but stable and the economy is otherwise humming along, says Ed Cole of Man Group, an asset manager. Managers should be able to control costs and adjust prices in response.
Moreover, during individual periods of high inflation, the historical record is less comforting for shareholders. Between 1900 and 2022, in years in which inflation rose above around 7.5%, the average real return on equities flipped from positive to negative. Even when inflation was lower than this, it tended to reduce the real returns from shares. In other words, though stocks tend to outpace inflation in the long term, in the short term they do not offer a true hedge against it.
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