A lot of people are looking to David Cameron and his coalition to steer the economy out of danger. But team Cameron have little room for manoeuvre – every time they try to make serious reforms, it seems to end up with a U-turn.
Today, the true power to steer the economy lies with Mervyn King and his team at the Bank of England (BofE). And as investors we need to get a grip on what the BofE plans to do. It could have massive repercussions for our holdings.
You know what I think is going to happen: Team King is going to play a loose game for as long as they possibly can. A bit of inflation isn’t going to bother them. And that means we need to take steps to protect our wealth.
Here’s why…
Four reasons why the Bank doesn’t care about inflation
It’s often argued that it suits the authorities to inflate away debt. If inflation goes up, then the interest government has to pay on its bonds becomes less onerous.
And I’ve got some sympathy with this argument. But to get away with this trick, government still has to hope that its income (taxes) goes up along with inflation. Some taxes will go up – VAT for instance. But others won’t. Taxes on profits and employment may still stall. And anyway, not all government bonds have fixed interest rates – some are inflation-linked.
It’s much more likely that the BofE will keep rates low to try to crank the economy into growth. With two-thirds of our economy made up of consumption, it’s vital that consumers keep spending. And for that we need to steer clear of a housing slump.
Nothing is more certain to bring on a house price crash than if interest rates go back to where they should be (around the 6% or 7% mark).
Which brings us onto the second reason the BofE doesn’t care about inflation. For the housing market, an inflationary side effect may be good news. Even if house prices flat-line, then in real terms they’re going down by around 5% a year (as inflation stands).
For home-owners, ‘flat-lining’ keeps them out of negative equity. It feels a whole lot better than a nominal loss.
But it’s not just consumers the BofE wants to gee up. The third reason for inflation-inducing low rates is that the it wants businesses to crank up borrowing and spending.
You may have noticed ‘project Merlin’ recently making the news again. Basically the government is telling the banks “We will make you lend to small businesses”. “But,” say the banks, “they don’t want our money!”
And as a small business owner myself, I can understand that. Few businesses are going to want to load themselves up with debt as we head into uncertain times. Sure there’ll always be businesses that can’t get credit. But let’s not get carried away by anecdotes from a banker-bashing press.
The point is that low rates are there to induce businesses and individuals to borrow. Creating debt is effectively creating money. And that’s what the BofE wants – an increase in money supply.
It doesn’t give two hoots if this is inflationary. It is far more worried about the other thing.
The real threat here is deflation
It takes a long time for the policy actions of the BofE to filter through into the economy. It knows that it can’t just turn up the gas and expect to bring the economy straight back up to the boil.
So, the BofE has left the gas ring on full. It knows that George Osborne is about to chuck a whole load of cold water in the pan. The BofE is fighting off a double-dip recession ahead of budgetary cuts as they come into play.
Even if we don’t get outright deflation, there’s no doubt that it’ll feel like we’re in a deflationary bust.
It’s fashionable to say that the BofE doesn’t know what its doing. And King has taken a lot of flak for getting his forecasts on inflation hopelessly wrong.
But the BofE is playing its own game here. King and his team think that a deflationary bust is a whole lot worse than a bit of short-term inflation. So they’re playing this out the only way they feel they can.
Of course it’s a dangerous plan. Leaving the gas on full pelt could cause an accident. It’s not how I would have played it. But there you go, I’m not in charge.
The point is either they’ll be proved right, or there’ll be a terrible accident. Either way, I’m expecting policy rates to stay low for a long time.
Here’s my safety plan
With interest rates staying low, I’m still long corporate bonds. As I’ve said before, with a bond you’ve got the promise of getting your interest and money back. And who knows what could happen with equities and their dividends if something nasty happens?
Talking to other investors, I get the impression bonds are largely ignored. I think that’s a mistake. And that’s why I’ll continue to search out the best ones and tuck them away for a bit of safety in case of a deflationary bust.
I’ve already showed you one of my favourite bonds at the moment and I’m going to keep you posted on some of the more interesting bonds available for private investors.
On Wednesday, it’s back to something that certainly isn’t suffering from deflation. And that’s oil. I want to look at a particular quirk in the market that could help us find the best way to play it.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.