As the world appears to be slowly recovering from the COVID-19 crisis, the specter of inflation hangs over developed economies. Should we be worried? A look back at a phenomenon whose name is often better known than its implications.
Inflation is a general rise in prices in an economy over a period of time. When prices rise, each monetary unit allows the purchase of fewer goods and services: as a result, inflation erodes the purchasing power of consumers. So, with annual inflation of 2%, 100 euros today will only be worth 98 euros a year from now.
In a capitalist system based on a growth model, inflation is - as long as it is anticipated and contained - rather a sign of the health of the economy. Indeed, even if inflation results in an erosion of purchasing power over time, when it is moderate and well anticipated, it is usually accompanied by a rise in wages, which makes it almost painless. This is actually "bad for good" because if the price of goods and services increases, producers increase their profits, which encourages them to invest and ultimately creates progress.
Unlike inflation, deflation is a general fall in prices over a period of time. In between, disinflation is a fall in inflation: the inflation rate falls while remaining strictly positive. In general, deflation is a phenomenon that economies seek at all costs to avoid, because it creates a vicious circle from which it is very difficult to escape: falling prices lead to lower company margins, wages, investments and financing possibilities of States which, as a result, also invest less.
To measure inflation, we use the inflation rate, which measures percentage changes in the consumer price index. This index is calculated on the basis of the weighted prices of a basket of goods and services of current consumption, sometimes also called “basket of the households”“basket of the households”, which includes in particular food products, products and services related to housing (rent, electricity, water, fuel, etc.), transport, telecommunications, leisure and education. Each year, new products and services enter and exit the index. In 2020, for example, non-alcoholic beers, shower heads and animal boarding houses entered the index, while landline cordless telephones and solar bench subscriptions left ...!
Several factors can cause inflation. The law of supply and demand first: if the demand for a product or service exceeds the available supply, its price will naturally increase, because the seller will find a buyer willing to buy his product at a higher price in order to have the certainty of getting it before another buyer. Then, the economic and fiscal policies put in place by the States obviously play a role. Finally, the European Central Bank (ECB) can cause inflation, in particular by playing on the interest rates on loans it grants to traditional commercial banks.
Each central bank effectively determines periodically a daily rate called the “key rate”, at which it remunerates the deposits of banks placed with it, and which will serve as a reference for these same banks to set the interest rate for consumer or investment loans it grants. This rate is also used as a benchmark for setting bond interest rates. There is therefore a direct correlation between inflation and interest rates: when inflation is low, central banks tend to maintain low interest rates to increase the borrowing capacity of economic agents, stimulate consumption and thus, as explained above, increase inflation. Conversely, when inflation is (too) high, central banks tend to raise rates to avoid overheating or soaring prices.
After the oil shock of 73, inflation reached record levels - close to 14% in OECD countries - and then gradually fell and stabilized around 1.5%, even raising fears of deflation. Since the 2008 crisis, central banks have therefore continued to implement so-called “accommodative” policies by keeping low interest rates to discourage savings, encourage credit, therefore increasing the monetary mass in circulation to promote consumption, and creating inflation.
So far, however, these policies have not had the desired effect: inflation has been stagnating at around 1.5% for more than 10 years. The causes of this failure are multiple: the new money masses created were distributed mainly by the banks to the richest companies and individuals, who did not especially consume more but saved or invested without effect on inflation; structurally, the technology that allows online shopping anywhere in the world has pushed prices down; and finally, the aging of the population and the decline in fertility in our economies have also slowed down consumption. Also, the “deconsumption” movement which essentially drives the younger generations - consuming less, but better, more local and more sustainable - could have a deflationary impact.
The cause of the current return of inflation will therefore have been ... a virus. Indeed, the pandemic and the successive “lockdowns” it has imposed around the world have had the effect of reducing the consumption of goods and services. While the measures are slackening thanks to vaccination, consumption is boosted, households having been forced to save for a year - some having even benefited from government bonuses. But supply does not follow, because companies have not yet had the time to adapt to the new context and revive production at full speed, which automatically pushes prices up. In the United States, the inflation rate reached 5% over one year in May, unprecedented for two decades, and 2% in Europe.
Most observers consider this phenomenon temporary or cyclical, unlike structural inflation due to persistent market anomalies such as a population decline decline or the introduction of a minimum wage, for example. This would be a post-COVID “decompensation” mechanism; consumer euphoria should quickly subside. This is also the bet of the central banks, which have affirmed their willingness to keep their interest rate policies low for at least a year. As a result, the markets for the time being also remain quite impassive: the indices are relatively stable and long-term interest rates have not soared.
In a scenario of high inflation that would prompt the ECB to raise the key rate, the attractiveness of risk-free assets (bonds) increases. Investors tend to reallocate their capital from stocks to bonds, lowering demand for stocks and therefore their price. However, in an inflationary environment, companies are normally able to generate profits equal to or greater than inflation, suggesting a relatively rapid rise in prices. This is particularly true for companies that can easily pass higher prices on to their customers: companies active in raw materials, real estate and retail to name a few.
Nothing is worse, with inflation, than being invested in cash: over time the value of your assets decreases, putting your future plans at risk. While inflation is here to stay, even at a moderate level, this is an incentive for investors to go public or increase their exposure. This allows them to offset the erosion of their purchasing power, earn income from their assets and thus be able to carry out their mid- or long-term projects. But while the stock market remains the best shield against inflation, diversification is obviously still required in order to mitigate the risk inherent in this type of investment. It will therefore be necessary to clearly define its investment horizon and its risk profile, in order to build a balanced portfolio in line with its objectives.
To visualize the impact of inflation on your portfolio, we invite you to do a simulation on the easyvest website. Once the simulation is done, click on Modify the plan, then on Edit in advanced mode, and finally on Modify detailed hypotheses. This will allow you to change the inflation rate and directly see the impact of inflation on the real value of your investment*.
*sorry for the complexity of this process, not really in our habits ;-)
Note: This article was written when Easyvest was authorized and regulated by the FSMA as an agent in banking and investment services.