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INFLATION: the unintended consequence.

Summary: Aggressive quantitative easing by central banks around the world runs the risk of re-igniting inflation discusses Gary Dugan, Chief Investment Officer, Asia and Middle East, Coutts N

Central banks around the world have been busy pumping vast amounts of money into the financial system in a bid to keep drowning economies afloat.

The main strategy central banks have been using to get money into the economy has been quantitative easing, known simply as QE. This might involve cranking up the printing presses and printing more bank notes or, as has been the case, central banks might do it indirectly, for example by buying government bonds. The intention is that QE will stimulate lending and consumer spending, which should help kick-start economic growth. However, such aggressive QE strategies could have a dangerous consequence - surging inflation.

The amount of money that has been pumped into the system by central banks since the financial crisis is staggering - and we are not finished yet. Since 2009, the Bank of England has bought Au375 billion of gilts, while the European Central Bank has bought e1/4772 billion of eurozone debt. Having already embarked on QE worth $1.9 trillion, the US recently launched its third wave, QE3, which is pumping an additional $40 billion a month into the American economy. QE3 is open-ended and will continue until employment improves significantly. Japan has also embarked on an unlimited QE programme, while the Swiss National Bank has undertaken to buy an unlimited amount of euros to support the single currency against the Swiss franc, thereby supporting Swiss exports and countering deflation. IN

The threat of high inflation often leads to thoughts of Britain in 1970s when inflation averaged 13 per cent and peaked at 25 per cent in 1975. It didn't slow down until 1983 - by that time a shopping bill that came to Au25 in 1970 had leapt to Au115.

Several studies have shown that doubling or tripling a country's monetary base has been a certain recipe for higher inflation. However, on the positive side, other studies such as the Federal Reserve Bank of St Louis report: Doubling Your Monetary Base and Surviving: Some International Experience have also shown that high inflation can be avoided if the public understands that the increased money supply is temporary and that the central bank really wants a low and stable rate of inflation. It is a conclusion to draw comfort from, but we should not be complacent.

The deputy governor of the Bank of England, Paul Tucker, recently stated that QE had "lost its bite". When he was asked how much fuel there was left in the QE tank, he replied, "Technically we could do more; it's just a question of what we think the risk to inflation would be." G

And therein lies the rub - it is policymakers' decisions that will be key. All the signs point to modest inflation - be it in the UK, the US or the eurozone - but an error of judgment by policymakers could result in unintended inflationary consequences.

Other risks could also threaten to push inflation beyond modest levels. Geopolitical tensions are one, with spiking oil the classic example. Major issues in the Middle East, such as the threat of conflict, could cause the oil price to surge and subsequently undermine any hopes for modest inflation.

An improved credit environment also risks higher inflation. Policymakers want banks to get lending again to stimulate the economy. But credit growth that results in a more robust economy could also fuel higher inflation.

INFLATION AND THE SLOW EROSION OF WEALTH

The consensus - one that we endorse - is for inflation to remain at current levels. In the UK we expect inflation to remain in the 2-3 per cent range for a couple of years.

Inflation running at such modest levels may not seem too much of a risk - but for investors who sit back and do nothing, it is. Even running at such levels, inflation will erode the value of wealth.

It has been almost four years since the Bank of England cut its base rate to a record low of 0.5 per cent. In the US, rates have been pegged at 0.25 per cent since late 2008 and are unlikely to rise until 2015, while the European Central Bank cut its rate to 0.75 per cent in July 2012.

With inflation running at around six to seven times such rates, savers face a severe challenge in trying to secure an above-inflation return on their money. Such a gap between interest rates and inflation causes havoc for your wealth because it erodes your spending power over time.

And that is just part of the story. Official inflation figures, such as the Consumer Price Index, are not a true reflection of many people's lifestyles. The costs of school fees, city property and private healthcare are rising at much faster rates, in many cases nearer double-digit levels.

Inflation is always a threat - whether racing out of control or rambling along at modest levels - and investors must always be mindful of the risk it poses.

What it means for you

Equities are a decent hedge against moderate inflation over the longer term, particularly those that pay rising dividends.

But gold is our favoured hedge against the erosion of spending power. As governments and central banks adopt policies, such as QE, to engineer higher inflation and currency depreciation to help ease their debt burdens, gold benefits. As a tangible asset in finite supply, gold's value will not be eroded by inflation; instead its value will increase as the value of currencies is eroded. In fact, gold benefits from the very measures used by policymakers to stimulate economic growth.

Investors should be aware however that gold is no panacea to protect wealth from inflation. Indeed the relationship between a pick up in inflation and a higher oil price is not a strong one. Gold does well where there is a marked and sustained threat of inflation where policy makers show limited ability to be able to control the inflation risk.

Currency weakening to support export competitiveness increases the value of gold in the depreciating currency. Ultra-low interest rates and negative long-term yields (once adjusted for inflation) negate the drawback of gold's lack of yield compared with cash, which can be a disadvantage when rates are higher.

Commodities, in general, are a hedge against the inflationary risks of current monetary policies such as QE. However, we prefer gold as it has the lowest economic sensitivity and so is less vulnerable to the prevailing risks of economic weakness. Gold is still vulnerable to a deflationary squeeze, but would benefit from the likely monetary easing response to such an environment from policymakers.

At this time the best way of thinking about hedging your wealth for a significant pick up in inflation is to weight your portfolio towards commodities and equities.

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Publication:Banker Middle East
Date:Feb 28, 2013
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