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After being given up for dead, inflation is beginning to stir.

After being given up for dead, inflation is beginning to stir. In many countries it’s still below the 2% level most central banks find ideal, but economic circumstances and attitudes of policy makers have shifted to suggest that the likeliest path of inflation is now up rather than down.

Market participants and central bankers will be relieved that the world is no longer battling the threat of falling prices and the accompanying economic instability. Also, a more “normal” rate of inflation is one of the conditions needed to support an increase in interest rates, which would be good for savers.

Many investors do not foresee longer lasting price changes to levels significantly above the norm. Yet our research suggests that many of the assumptions underpinning that conservatism are no longer warranted: We do not anticipate excess capacity and low oil prices lasting indefinitely; nor do we expect elected governments to remain fixated on austerity; and we are not convinced that central banks will clamp down if they see inflation about to exceed 2%.

The best gauge of spare economic capacity is, arguably, the unemployment rate. Across the 34 nations in the Organisation for Economic Co-operation and Development (OECD), employment has been falling steadily from around 8.5% in 2009 to the OECD’s projected rate of around 6.0% in the fourth quarter of 2017. In major countries such as the US, UK and Germany, full employment has been reached and growth in the real value of salaries (i.e. what they can buy) is rising sustainably for the first time in a long while.

Typically, high unemployment drives inflation down (fewer people earning money meaning that prices have to be lowered and wage increases are hard to justify), while low unemployment pushes it up. The recent trend of inflation staying low as unemployment was also falling led some economists to worry that this relationship had broken down.

However, our analysis suggests that the relationship is intact. For the first time since the crisis, labour markets and commodity prices are pushing prices in the same direction, which is up. The main force that we expect to further boost inflation is fiscal stimulus. Both the UK and US have announced significant infrastructure plans, while tax cuts have been stated as a priority of the Trump administration.

In short, inflation is set to be a significant factor affecting economics and investments over the coming years. The potential for inflation rising above 3% in the UK and several other major economies is no longer insignificant. If it were to happen, this would be a major structural change for the global economy and financial markets. This is one of the potential scenarios for which we are preparing.

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Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at  February 2017. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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