Why a tight belt is the best way to strangle inflation

Unpleasant as this extended belt-tightening may be, it is preferable to the less obvious but real attack on our wealth that the return of a really inflationary mindset would entail. Inflation is not just painful, it is dangerous as its superficial attractions mean some people are happy to let it creep up . As we have seen this week, 5pc can too easily become the new 3pc. For governments, the siren call of rising prices can be hard to resist. Although, there are more index-linked liabilities today than there were in the 1970s, rising taxes from higher nominal incomes, especially as people are dragged into higher tax bands, and the fixed cost of servicing bonds can look like a pain-free solution. For individuals, ?money illusion? ? the idea that higher nominal wages make you wealthier even if prices are rising too ? can disguise the distortions created by inflation. Money goes to the most militant, pensions and benefits lag prices ? especially if linked to misleading inflation indices ? and investment returns look reasonable but fail to maintain the living standards of those who depend upon them.

Most dangerous of all, people conclude that saving is pointless and that excessive debt is riskless as inflation will rapidly erode the real value of their borrowings, which will dwindle relative to the value of the asset against which they are secured.

Because companies quickly adjust their behaviour, investors will also have to rethink their approach in an inflationary environment and some received wisdom won?t look so clever.

The idea that retailers were better off not owning their premises made sense in a low inflation world but would have been laughable in the 1970s and may be again. Debt-financed balance sheets look sensible if the real rate of interest is negative as it tends to be against an inflationary backdrop. Above all, cash is king and companies which turn over their assets quickly, like supermarkets, look a lot safer than businesses that don?t, like house-builders.

We?re a long way from the 1970s when these kinds of issues preyed on investors? minds but forewarned is forearmed.

? Tom Stevenson is an investment director at Fidelity International. The views expressed are his own. tomrstevenson@fil.com . Twitter: @tomstevenson63

latest business news latest economics news latest finance news latest investing news business