August 2009

Tentative signs of economic rejuvenation have led to concerns in recent months about central banks' "exit strategies". Specifically, investors are worried that the monetary authorities may react too late to the changing economic outlook in reining in the expansionary policies that were the response to last year's financial crisis; in particular, they fear the long-term inflationary implications of flooding the financial system with liquidity.

Near-term inflationary concerns would appear exaggerated (year-on-year inflation in the Euro-zone, for example, is currently falling for the first time in the history of the European Union). Looking further out, however, there is the risk of central banks not clamping on the monetary brakes in time to prevent a sudden, strong recovery from developing into an inflationary bubble. Equally, tightening monetary conditions too soon in a nascent upswing could jeopardise its durability. Managing the next recovery could therefore be a tightrope walk for central banks.

Few analysts believe that a sustainable economic recovery can occur without rising prices. However, prices can still rise even in periods of lacklustre economic activity; oil price movements, for example, often have more to do with geopolitically-induced supply fears than with final demand levels. In other words, inflation is always a potential threat, regardless of what phase the business cycle may be in.

While there is no consensus currently, the risk of inflation becoming the next nightmare for the global economy is generally acknowledged, although the impact may vary from region to region. The ECB has a mandate to maintain price stability, but the Federal Reserve has no such mandate (focusing more on employment) and the rest of the world is unlikely to remain completely unscathed by an inflationary boom in the world’s largest economy. In any case, the ECB tackling inflation head on by raising interest rates sharply might not only undermine any European recovery, it could also intensify the financial burden already borne by the EU’s highly indebted member states, leading perhaps to sovereign debt downgrades by the rating agencies.

Whichever economic scenario unfolds, investors will seek to adapt their portfolios quickly. Should an inflationary environment come about, traditional hedges such as property and gold are likely to do well; commodities whose price increases would presumably make them primary inflation drivers should also benefit, as would the equities of companies with pricing power. Should prices remain stable, however, implying minimal growth and steady interest rates, fixed income could become the most popular asset class: government bonds, though yielding little, will provide relative safety, while selective corporate bonds will attract the more risk-oriented investor.