'CASH:
A HEDGE AGAINST INFLATION'
Is
cash a better protector against inflation
than index-linked gilts?
With
gold and oil prices at record highs, and
the global money stock rising rapidly,
you can be forgiven for wanting to buy
insurance against rising inflation.
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But
this is currently very expensive. At the time
of going to press the real yield on longer-dated
index-linked gilts is approximately 1. 5 per
cent, and the yield on index-linked national
savings certificates is no better.
Luckily, though, there might be a simple alternative:
plain old cash. Both theory and recent history
says this should protect us against inflation.
The theory is the Taylor rule, named after Stanford
University’s John Taylor. This says that
if inflation rises, interest rates should rise
even more. So higher inflation means higher
real rates for savers. One such rule is:
Interest rate = 1.25 + (1.5 x RPIX inflation)
+ (0.5 x output gap)
This rule says interest rates should be 5 per
cent if inflation is 2.5 per cent, rising to
6.5 per cent if inflation rises to 3.5 per cent
(assuming output stays on trend). These imply
real rates of 2.5 per cent and 3 per cent respectively.
And the Taylor rule has been pretty accurate.
Since 1986, the correlation between threemonth
interest rates and the Taylor rule forecast
has been 0.91, with rates being more than 1.2
percentage points below the Taylor rule only
one sixth of the time.
Thanks to this, three-month rates have been,
on average, 3.8 percentage points above headline
retail price inflation since 1986. That’s
better than the average real yield (2.9 per
cent) on index-linked gilts over this time.
One reason why index-linked gilts are bad value
is that they don’t just protect us against
inflation. Pension funds buy them because they
match funds’ liabilities. This demand
means index-linked gilt prices are high. Retail
investors, who don’t need this liability
matching, therefore get a poor deal from them.
So why should be bother with them at all? Three
reasons:
1) Tax. This interacts nastily with inflation.
Imagine inflation were to rise to 5 per cent
and the Bank of England were to obey the Taylor
rule. Rates would rise to 8.75 per cent (assuming
no output gap). For a top-rate taxpayer, the
post-tax interest rate would be just 5.25 per
cent, implying a real rate of just 0.25 per
cent.
2) Recession. If output slumps far below trend,
real rates would fall. But this probably isn’t
a big problem, as such a recession would bring
inflation down, restoring cash’s attraction.
3) The Bank could deviate from the Taylor rule.
A big financial crisis might cause it to cut
rates even if the inflation outlook doesn’t
warrant it. Or if a big rise in commodity prices
threatens to cut growth, the Bank might not
raise rates as much as it should. Although the
Taylor rule has tracked rates well since the
1980s, it did a poor job of doing so in the
1970s, partly for this reason.
I suspect it’s this last risk that justifies
why retail investors should consider holding
some index-linked gilts.
Richard Kleiner
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