‘Transitory or not transitory? That is the question’, to paraphrase Shakespeare’s Hamlet. The past few days have seen a slew of inflation data from the major western economies. As we noted last week, US Consumer Price Inflation (CPI) for December tipped the scales at 7.0% year-on-year, against 6.8% the previous month. This week December UK CPI came in at 5.4%, again up from 5.1% in November (and, in context CPI this time last year was 0.7%); the Retail Price Index (RPI), which includes owner-occupied housing costs excluded from the CPI data and which is still used in wage negotiations and pricing of regulated goods and services (e.g. rail fares), hit a whopping 7.5% year-on-year.


The rising trend, albeit at a slower rate of increase, was seen on the Continent too, with eurozone CPI reported at 5.0%. Both the Bank of England and the European Central Bank (ECB) were at pains to stress that inflationary pressures are likely to be more enduring than thought only a few months ago, although the inexorable progress of time suggests that mathematically the relative burden will diminish as the comparative figures become easier.


What those banks are essentially saying is, “we know this is hurting. Much of what is driving it, particularly energy costs connected to the Ukrainian crisis, is exacerbated by Covid-related supply-side problems beyond our control. But we’re keeping our fingers and toes crossed that if commodity prices have more than doubled in the last 12-18 months, they’re unlikely to double again over the next year”. If they’re right, then although there may yet be worse to come in the immediate future, the pressures on a comparative basis will gradually resolve themselves. Time will tell if they are right.


But the key question is not so much whether the pressure is transitory, but at what rate does inflation eventually settle? Even if there is no great anticipation of CPI rates persistently in high single digits, 3%-5% would still be significantly greater than the central banks’ common mandated targets of 2% (nominal for the Bank of England and the ECB, average for the Federal Reserve over an indeterminate period). Interest rates are still rock bottom, hovering either side of zero (-0.5% in the eurozone, zero in the US and 0.25% in the UK).


That massive differential between the inflation rate and the interest rate represents the real negative return on keeping cash in the bank; it is a significant disincentive to hold cash as the failure of the interest rate at least to match inflation means active erosion of the purchasing power of deposited currency. Indeed, in Europe it is even worse: a negative nominal rate of deposit interest means even before thinking about the corrosive effect of inflation the depositor is paying for the privilege of lending money to the holding bank—a constant source of friction between Germany and the ECB that the central bank is perpetrating theft of depositors’ earnings, acting both immorally and illegally. 

The broader conundrum of negative cash real returns 

And it is not just bank interest which carries a negative real rate of return. Even after yields have risen in expectation of the central banks having to hike interest rates to stem inflation, most western 10-year government bond yields are still substantially below the rate of inflation: US 1.84%, UK 1.22%, Germany -0.03%. That is not new. However, what is new is that the average real yield on dividends from shares is now negative too. Take the FTSE 100 (we choose the UK index because of all the major comparators, the UK has the most mature and embedded dividend culture); the estimated yield for 2021 (estimated because many companies are yet to declare their final dividend for the year just ended) is 3.4%, exactly two percentage points below the current inflation rate. However, in contrast with non-index-linked bonds, shares generally do provide a level of inflation protection. This is partly because most companies like to have ‘progressive’ dividend policies in which cash distributions rise over time; it is also partly that those companies which invest in long-term brands, product innovation and new technologies and which are price-setters in their industry rather than price-takers, are better able to withstand the ravages of an inflationary backdrop which over time is reflected in their share price performance. 

Central banks’ limited options 

What are the central banks to do? We have made the point before, but it stands repeating: central bankers have only two principal levers at their disposal with which to control the economy. One is interest rates (which are primarily used to change behaviour on the demand-side of the equation) and the other is to speed up or slow down the supply of money, the majority of which is now effected through the process known as QE, quantitative easing, which chiefly involves buying government bonds.


As economic growth begins to show signs of stuttering, partly thanks to Omicron, partly due to the ongoing effects of supply-chain blockages, at this stage in the cycle, bankers would be thinking of reaching for the lever labelled “lower interest rates”, only they can’t because interest rates are against the stops already (thanks to the response to the Covid-inspired economic collapse of 2020). That period of moderate economic growth in the late 2010s was largely squandered as an opportunity to restore an arc of travel for the relevant lever (the Federal Reserve made a half-decent stab over the two years from December 2015, until Chairman Powell made his crashing policy U-turn in January 2018 in a panic response to falling equity markets, what became known alliteratively as ‘Powell’s Policy Pivot’). Meantime, markets and politicians in particular are demanding action to address the inflation problem, one which screams, “Raise interest rates now!”, precisely the opposite action to the antidote to slowing growth rates. 

The blind leading the blind? 

It is a hole largely of the banks’ own making. In seeking to reassure markets through the tautological Forward Guidance in which central bankers attempt to own the narrative of the future trajectory of monetary policy so they themselves avoid being part of the problem, their collective long-term projections of policy stability for the foreseeable future (in the case of the Fed, out to 2024) has been well and truly rumbled. They are now in the business of fighting a rear-guard action while fully engaged, in the meantime still trying to convince everyone else they are fully in command of the situation. It is fair to say that as things stand today, the markets and inflation have the upper hand, the banks are trailing in their wake.


Nobody is pretending that the current situation is not immensely complex. However, central banks are key economic policymakers. There is an implicit supposition that being part of the national policy leadership team, they know what they are doing (when it comes to our political masters, many might disagree given the current shenanigans in Westminster), all will be well. Confidence tends to ebb when either the banks try to defend the indefensible, or the suggestion is made that in reality, they know no more about what is likely to happen than the rest of us. That is largely the situation in which we find ourselves now.


The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions. 

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