As the UK emerges from lockdown, pent-up demand looks set to push prices higher, but the longer term picture for inflation is more mixed
The spectre of inflation is stalking financial markets once again.
Take a look at our glossary for explanations of the investment terms used throughout this article.
Having fallen to record lows in the height of the COVID-19 pandemic, the yields on longer-dated government bonds issued by countries like the US and the UK have again been rising – and sharply. The recent uptick in bond yields is at least partly attributable to rising expectations for inflation in future years.
Inflation matters for investors because it can erode the real value of a bond and its income over time, much as it will reduce the real value of cash or any other asset that doesn’t keep pace with rising prices.
Here, we explore some of the reasons why although inflation might be heading up in the near future, we believe the longer-term case for higher inflation is less clear cut.
Our starting point is one where inflation is near historic lows. With economic activity suppressed by the pandemic and social lockdowns, consumer prices have barely risen recently. In February 2021, the consumer price index (CPI) measure of UK inflation was only 0.4%.
Official forecasts now predict a return to inflation. In February 2021, the Bank of England projected that CPI would rise back to 2% – the target UK inflation rate – from the first quarter of 2022. But could inflation rise higher than this?
The huge and continued levels of stimulus from governments, in the form of greater spending, and central banks, in the form of very low interest rates, should put upward pressure on inflation. After all, greater government spending in the economy, combined with low borrowing costs that encourage business investment and consumer spending, would be expected to push demand and consequently prices higher.
Of course, we would only see the release of pent-up demand as the economy reopens and returns to growth. People will doubtless be keen to do things they were forbidden from doing during lockdown, such as going to restaurants, theatres and on holidays, and may be willing to pay more – when they can afford to.
So, inflation might be set to rise in the short-term, but the longer-term picture appears more mixed.
Global bond market investors certainly look to be expecting higher inflation in the decades ahead. The yields on long-dated government bonds (those that mature decades in the future) give an indication of what investors expect inflation to be.
Their recent rise tells us that these expectations have been rising. The chart below shows the implied long-term US annual inflation rate based on the yields of 30-year US government bonds. This is an important benchmark for global investors. We can see these rose above 2% in early 2021.
Source: Bloomberg, 18 February 2021
Historically speaking, though, annual inflation in the order of 2% would be relatively low. Indeed, these expectations of future inflation – although they have risen recently – reflect the powerful forces that have kept inflation low for the past few decades. Deflationary trends including globalisation and technological advances, both of which have reduced inflationary pressures, look unlikely to reverse.
Additionally, the potential long-term economic damage caused by the pandemic could keep a lid on inflationary pressure, especially if support from extra government spending and rock-bottom interest rates is unwound earlier than anticipated.
While the future path of inflation remains as unpredictable as ever, this is the first time for many years that we have seen several forces emerge that are likely to put upward pressure on inflation, at least in the near term.
There are ways you can aim to navigate rising inflation. If you think inflation could go up in the long term, it is worth asking whether and how your savings and investments could be affected. After all, you need your investments, and the income from them, to maintain the value of your buying power.
Investments that offer the potential to rise in value with inflation (or deliver an income that rises with inflation) could protect you from the risk of seeing the purchasing power of your savings go down.
As well as inflation-linked bonds, whose income coupons and value will track a measure of inflation, company shares and property assets also have the potential to offer protection against the threat of rising inflation over time.
If you are concerned about higher inflation, you may wish to consider seeking financial advice. Speaking to a financial adviser can help you define an up-to-date investment plan, unique to your goals and needs.
Please bear in mind that M&G is unable to give financial advice. The views expressed here should not be taken as a recommendation, advice or forecast.
The value of any fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested.