This time last year, Bank of England governor Mervyn King told us that by now Consumer Price Index (CPI) inflation would be down to 1.7%. It isn’t. Instead it is at a near-three-year high of 4.5%. He couldn’t have been much more wrong. Dylan Grice, who I interview this week, has had enough. King, he says, is “deeply flawed” and a prime example of why all central banks should be dumped in favour of free banking – a system under which we leave setting interest rates to the market.
Not everyone would want to go quite so far, but it is true that the world’s central banks have done an almost unbelievably awful job in guessing where inflation will be, and rates should be, over the last decade. You might ask why. I wonder if it isn’t because the changes in price levels since the mid-1990s have not been demand-led, but supply-led. The pleasantly low inflation of the pre-crisis years – which left CPI inflation hovering around the bank’s target and allowed it to justify overly low interest rates – didn’t reflect levels of demand in the West so much as the fast-falling prices of all the consumer goods coming in from the East. And the inflation we are seeing now, again, isn’t about demand in the West. It is about supply: it reflects not a consumption and investment frenzy here, but the newly rising prices of imported consumer goods and of commodities.
Asia’s demand-pull inflation is our cost-push inflation. That’s not something most money managers today have much experience of. It also suggests that if they are after a vibrant domestic economy, CPI might not be the thing central bankers should be watching. Raise rates in an environment of overheating demand and you will probably find you have done the right thing (although almost inevitably too late). Raise rates when credit is already hard to come by, millions of mortgage holders are hanging on by their fingernails, real wages are falling, and retailers are reporting rubbish sales, and you probably won’t. Tricky times.
So what does the investor do? Given that there is not one single account in the UK that would give a real return to a 40% taxpayer at current inflation levels, you probably don’t fancy holding cash much. But we still think you should have a reasonable amount. Why? Most other things look overpriced and risky. But cash comes with what Grice calls “optionality”. If prices of other things fall and you have cash, you have the option of buying them. Other people don’t. You will say that cash isn’t risk-free either: hang on to it and it looks like you are all but guaranteed to lose 4%-5% in real terms every year. That’s true. But what is also true is that right now you have a chance to put £15,000 of your cash in a place where it gets to keep its optionality and to guarantee you a real post-tax return. That place is NS&I index-linked savings certificates.