Here comes the inflation beast

The sharp rise in consumer price inflation, which began around the spring of this year in many currency areas around the world, was a warning shot to many investors. It clearly shows that “inflation is not dead”, but that the “inflation beast” can rear its ugly head quite powerfully. Of course, special factors and, in particular, strongly rising energy prices (for, say, oil, natural gas, coal etc.) are driving headline inflation indices higher. However, there is room to expect that the upward drift in inflation will not ease off anytime soon.

In an effort to cope with the economic fallout of the politically-dictated lockdown crisis in 2020, central banks slashed interest rates to exceptionally low levels and increased the quantity of money significantly. The result is a fairly large “monetary overhang,” which will help drive prices for goods and services higher – especially in an environment where supply bottlenecks have remained severe, and production and logistic chains are still very much out of step. These “cost-push” factors could thus all too easily fuel upward price pressure further.

This, in turn, puts the credit-based monetary system in dire straits. Because if consumer goods prices continue to rise for all eyes to see, peoples’ inflation expectations will likely go up. In other words, people will expect an inflation rate that is higher than the target inflation rate of the central bank and incorporate such a higher rate into their contracts (for leases, loans, wages, etc.). This, in turn, will lead to big problems. If the central bank allows a higher-thanpromised inflation rate, an upward inflation spiral could be set in motion.

If, however, the central bank takes action and raises interest rates and reduces credit and money supply growth to lower actual inflation and thereby curb inflation expectations, the economy and financial markets will most likely collapse – as the current recovery is no doubt fuelled by ultra-low interest rates and most generous increases in the supply of credit and money. Credit markets, in particular, would be vulnerable to any appreciable tightening of monetary policy – as borrowers might not be able to roll over their maturing debt and/or cannot afford higher borrowing costs.

So what are central banks doing? Their representatives, aided and abetted by quite a few mainstream economists, try to make the general public believe that the current inflation is just “temporary” and caused by “special factors,” the effects of which will soon disappear. Policymakers are trying to dispel the notion that high inflation is here to stay. They want to convince market agents that there is no need to distrust central banks’ inflation promise and that people do not have to raise their inflation expectations because everything will be just fine.

The truth is that the scenario of rising inflation and possibly rising inflation expectations on the part of market agents is a rather explosive constellation. A fairly critical point is when inflation leads to higher goods prices, as blue-collar and white-collar workers seek compensation for the loss of purchasing power in their current wages. In turn, higher wages would compel companies to charge higher prices for their products. Once kicked off, such a “price-wage spiral” typically has to be ended by a harsh restrictive monetary policy, causing recession and perhaps even deflation. 

If supply-side bottlenecks in the goods and energy markets were to ease noticeable in the near future, and market agents continue to sit tight and maintain their confidence in central banking, the very troublesome scenario outlined above could, of course, be prevented. However, it should be clear that the current stance of monetary policymaking around the world – keeping interest rates at record lows, greatly increasing the money supply, and allowing inflation to rise – even temporarily without changing policy, is a rather dangerous way of running things.

So here comes the “inflation beast”. What can the investor do about it? And what role can gold and silver play in the investor portfolio? Central banks worldwide can be expected to stick to their inflationary policy, delivering elevated but not necessarily runaway inflation in the months to come; this is the base line scenario. That said, chronic inflation – the ongoing loss of purchasing power of official currencies such as the US dollar, the euro, the Chinese renminbi, the British pound etc., be it in the form of consumer goods price and/or asset price inflation – will continue. The downside risk is that it will end up in a high and even explosive inflation regime, followed by a big crash.

That said, the long-term oriented investor might want to remain exposed in the market for real assets – such as stock and housing markets. This provides them with an opportunity to hedge their capital against the inflationary machinations of central banks. Gold and silver also come to mind. The quantity of these precious metals cannot be increased at political expediency or debased like official currencies like the US dollar, euro & Co. This means that physical gold and silver should be able to avoid the fate of permanent devaluation.

At the same time, however, the investor must be patient when holding physical gold and silver. As the recent past has shown, the price of gold and silver can be subject to substantial gyrations in the short run, and it is no guarantee that their prices will steadily move upwards over time. In fact, the numerous market interventions by central banks, which have now become “standard practise”, may lower investor “safe haven” demand for physical gold and silver, potentially causing periods of “counterintuitive fluctuations” of their market prices. 

However, if the investor manages to obtain gold and silver at an attractive price (that is, by buying them when almost everyone else is selling, for example), these metals can be seen as insurance against the whims of central banks’ inflationary policies, providing the investor with a considerable upside price potential in a period when the going gets rough. In such times the holders of gold and silver may have a “last line of portfolio protection” or even take the chance to convert high-priced precious metals into undervalued assets, thereby increasing their return on capital.

Thorsten Polleit, Chief Economist of Degussa