Investors beware – inflation is on the way

Last week I was chatting to a friend who’s been pumping serious money into some crowd-funded businesses.

“You see Bengt, I’ve been too careful over the last few years. I’ve had too much cash sitting on the sidelines earning sod all. And where’s all that inflation I was supposed to be worried about? It doesn’t seem to be coming, so I’m fixing in some decent rates on new loans in the real economy.”

He makes a good point: where exactly is all this inflation we were told to worry about?

The central banks have pumped so much money into the system – why hasn’t that produced inflation?

Well, it has. And where is it? Exactly where you would expect it to be – where all the money is, in financial assets.

In the real world we’ve been insulated from it, so far. But if I’m right, at some point soon you’ll be seeing inflation come to a town near you.

Crowdfunding is on the up

So, crowdfunding and peer-to-peer (P2P) lending are taking the world by storm. City analyst Liberum estimates P2P lending in Britain could grow from around £1bn today to over £45bn within the next ten years.

These blistering growth prospects are why the MoneyWeek team has prepared a report on the phenomenon for our readers.

It’s little wonder that P2P lending is taking off, really. With banks paying next to nothing on savings and cutting down on lending, of course borrowers and savers will cut out the banks, if they can.

It’s all aided by the internet, which has allowed direct lending to individuals (peer-to-peer) and business (crowdfunding) to prosper.

Just last week a brand new investment trust launched, targeting a yield of 6-8% by lending on online marketplaces such as Funding Circle, Zopa, Ratesetter and Crossflow.

All very interesting. But what’s it got to do with inflation?

How inflation spreads into the economy

It’s quite simple really: where money flows, inflation follows.

Just think about it: over recent years, untold amounts of newly-created money has poured into the financial system from the central banks.

And yet we haven’t seen any excessive consumer inflation, because the money has been too busy inflating financial assets instead.

Just take a look at the corporate bond and stock markets. Hell, let’s include London’s housing stock too.

Money has flowed into bonds, stocks, houses. And in each case, prices have rocketed.

Inflation occurs wherever the money goes to work. Simple.

But now it’s leaking out into the real world

Peer-to-peer lending has certainly made a timely entrance on the scene. But here’s the thing: all of this crowd-funding and peer-to-peer stuff is by itself opening new channels for inflation to leak out.

Put simply, all that printed money coming out of the central banks that wound up inflating financial assets, is now being let loose on the real economy.

My friend was telling me about the bike hire company, the gift shop, the fashion retailer… (the list went on, and on) that he’d loaned money to.

These aren’t arcane financial instruments – they’re investments in the real economy.

And as this money chases about the system, prices will push up. That’s inflation. Remember, inflation follows the money.

Inflation in the real economy could spell disaster

Now, I have absolutely no problem with crowdfunding. I think it’s a wonderful thing – as does the government, which has invested £40m in Funding Circle, a peer-to-peer lending marketplace.

What I’m saying is that increased peer-to-peer lending could be just the beginning.

Sure, it may be mostly confined to P2P lenders right now. But do you really think that the big commercial banks, forced for years to lock up their money in low-paying financial assets, don’t want to get involved too?

For the time that it’s just niche lenders, the inflationary effect will be relatively small. But once the commercial banks start lending out the money the central banks have given them – once those billions of pounds start entering the real economy – then we might have a problem.

What sort of problem? Well, a trickle of inflation can quickly turn into a downpour. All you then need are a few untimely global developments, like rising energy and food prices, suddenly you’ve got an inflation problem.

When that happens, watch the central bank belatedly raise interest rates to subdue inflation and keep the pound from tumbling.

And then you’ve got real problems – especially if you’re over-borrowed. Rising interest rates would make your loans much more expensive to service.

As it unfolds, investors will lament the day they tied up money in loans made to strangers on the web.

Now, I’m not saying inflation will strike tomorrow. But the mechanism is surely in place to let it out soon enough. As investors, we need to keep our eyes peeled.

On Friday we’ll catch up with our classic inflation hedge, gold.