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Should you prepare your portfolio for high inflation?
Volatile oil prices may not necessarily lead to high inflation, but they are a very unwelcome shock for a global economy, says Cris Sholto Heaton.
High inflation is surprisingly hard to forecast. It's tempting to assume that the results of a major event – such as the current Middle East crisis – should be easy to predict. Yet while this must push up energy prices in the short term, it is not so simple to say whether it will drive sustained broader inflation. There are far too many factors involved, and it is often impossible to anticipate which ones will prove most important.
Consider that during the 2010s, many people – including most of MoneyWeek – expected that extreme monetary policy – including interest rates at zero and vast amounts of quantitative easing (QE) – must lead to a rapid resurgence in inflation. This very clearly did not happen.
Why? Maybe this inflationary force was offset by disinflationary forces such as globalisation (cheap imports from China), productivity gains through technology and falling energy prices from the US shale revolution. Maybe the overhang from the financial crisis and the eurozone crisis, combined with government spending curbs, kept the economy below capacity. Maybe consumers and businesses hoarding cash or a reluctance by banks to lend meant the huge increase in the monetary base did not result in a similar increase in broad money (ie, what's circulating in the economy).
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That's already no shortage of explanations – and there are others, but this space is short. Which you prefer may depend on your taste in economics; none seem definitive.
Jump ahead to the pandemic and the result was different. Central banks eased aggressively once more, but this time inflation soared within two years. Why? The energy price shock from Russia's invasion of Ukraine. The lagged effects of supply-chain disruption from the pandemic. Pent-up consumer demand and changing spending habits. A tight labour market pushing up wages. High levels of government spending, including money that went directly to individuals and businesses. Again, take your choice.
So we can't be too certain how this new shock will play out. Higher energy prices feel inflationary, but if they weaken the economy, the effect may be temporary. Central banks are less likely to sit on their hands this time, though you can debate whether tightening policy in the face of a supply shock is a sensible thing to do – maybe it just doubles the harm.
Set against that, the AI boom is hugely energy intensive, which may amplify the effects – unless, of course, the jitters in private credit start to squeeze the funding it needs for growth. But perhaps the key factor is that it now seems politically impossible for government spending to fall (the US has a 6% budget deficit in a booming economy) and this will surely be funded by central banks through QE if markets baulk. So my guess is that this energy crisis will be another upward shock for a world that already has an underlying bias. That doesn't mean double-digit inflation – but we are not getting back to central banks' 2% target soon.
(Image credit: Federal Reserve Bank of St Louis)
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Cris Sholto Heaton is the contributing editor for MoneyWeek.
He is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is experienced in covering international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers.
He often writes about Asian equities, international income and global asset allocation.
