Inflation and Strategic Asset Allocation

Co-authored by Virginie Wallut, François Rimeu and Pierre Schoeffler.

A brief history of inflation 
 

Beyond the fluctuations in economic growth that guide tactical asset allocation, the most fundamental question for strategic allocation is the inflation regime that the developed world stands to experience in the coming years. For a variety of reasons, we may currently be at a major crossroads and at a time of radical change.For almost 25 years, from 1960 to 1983, the world lived through the consequences of the monetary disorder that led to the end of the Bretton Woods Agreement in 1973, which established just after the Second World War a fixed exchange rate system with the dollar-based "gold-exchange" standard. This system could only function due to a permanent influx of dollars into the international economy, which led to very accommodating monetary policies –an essential condition to ignite inflation. The oil crises of 1974 and 1979 acted as the triggers for the period of Great Inflation, which raised consumer prices in the developed world from around 4 to 10%, with automatic wage indexation to prices further fuelling the fire.

Then, for 40 years, from 1983 to the present, the developed countries changed their inflation regime to the Great Moderation, i.e., inflation between 0 and 3%. The man responsible was Federal Reserve System (FED) Chairman Paul Volcker, who raised the Fed's key interest rate to 20% in 1981 and adopted a strict policy of controlling the growth of the money supply, causing a severe recession. The lack of monetary fuel and the end of price-indexation schemes for wages have permanently broken inflationary expectations. Then came globalisation with the fall of the Berlin Wall in 1989 and China's entry into the World Trade Organisation (WTO) in 2001. The persistent deflationary pressures caused by the constant introduction of comparative advantages in the freetrade world have moderated wage demands while increasing household purchasing power. 

But globalisation has experienced serious headwinds over the past 15 years: the Global Financial Crisis of 2008, the clash between the United States and China from 2018, the pandemic in 2020 and the war in Ukraine in 2022. The world economy remains globalised, but fragmentation and segmentation are its new watchwords, with fewer competitive advantages and less of a network effect.

On the central bank side, it all started with the ultra-accommodating monetary policies put in place in 2009 in the United States and in 2015 in the eurozone to counter the effects of the global financial crisis, with the corollary of money supply growth of more than 20% at an annual rate over a long period. The fuel was in place. The onset of Covid then ignited inflation with a constraint impact on supply linked to containment and an overstimulation impact on demand linked to public support measures.

Then, comes the pressure for climate transition. The price of the carbon externality, which until now has not been taken into account, but which is the only truly effective instrument for passing through climate transition safely, will weigh heavily on energy prices. After all, economic activity is nothing other than the transformation of energy. The price of carbon will rise inexorably, as it reflects the present value of climate damage that is largely expected to occur after 2050, a date that is looming large ahead of us but closing in fast.

All this points to a rising trend in inflation. Other structural developments such as an ageing population could interfere with this trend in one direction or the other.