I started school on the Gold Coast in 1973.  During that first year of school, my weekly banana Paddle Pop cost five cents from the school tuckshop.  By the end of 1974, the price of that same Paddle Pop had risen fourfold to the princely sum of 20 cents.  I asked the tuck shop lady why the price of my Paddle Pop had quadrupled.  She said “that’s inflation son.”  And so I had my first experience of the dangers of rampant inflation, and the damage it could do to the treat budget of a seven year old boy, and from that moment on, I was probably doomed to study economics.

Australia’s annual inflation rate started the 1970s at a little over 2 per cent.  By the end of my first year of school it had climbed to 12.5 per cent, and ultimately peaked at 17.7 per cent in the March quarter of 1975. The 1970s was a disaster for more than just fashion – high inflation and stagnant growth decimated equity and bond investors alike.  It wasn’t until the 1980s – and in Australia’s case the early 1990s – that central banks around the world managed to bring inflation back under control.  During much of the 1980s and 1990s, inflation and bond yields declined across the globe, providing very strong tailwinds for world share markets.

For past two decades or so, low inflation has been so well entrenched, and inflation expectations have been so well anchored, that investors could be forgiven for a degree of complacency about inflation.  However, in the aftermath of the world’s major central banks have reduced short-term interest rates to extraordinarily low levels, and in the case of the US, the UK, Japan and Switzerland, used quantitative easing – massive injections of liquidity into the financial system in a bid to stimulate growth.   With monetary policy so extraordinarily accommodative, is there a risk that higher inflation – perhaps uncomfortably high inflation – could be the end result?

It isn’t difficult to imagine scenarios where this could occur.  What if policymakers tighten monetary policy too slowly, and labour shortages and wage pressures emerge at higher levels of unemployment than previously thought? In other words, the natural rate of unemployment is higher than policymakers think. What if consumers and businesses begin to expect that quantitative easing will lead to higher inflation – such expectations could become self-fulfilling, if they become factored in to wage and price setting decisions? So far, consumers’ inflation expectations are still well-anchored, but we can’t be certain this will persist.

Professional investors should always worry about inflation, even during times of apparent complacency about inflation, not least because it is real or after inflation returns that are important – and indeed are much more important to investors than strong peer-relative or above benchmark returns.  Above benchmark or top quartile returns are nice, but they aren’t of much use if investors can’t earn enough to keep up with the price of Paddle Pops.