Rising inflation looks to be a dead cert, but what form will it take and do schemes need to start thinking about hedging? Emma Cusworth investigates.
“The probability of a period of sustained high inflation has increased. That has driven up the cost of inflation protection, but it may still be worth protecting against.”Jignesh Sheth, JLT Employee Benefits
Inflation in the UK is all but guaranteed to go up in the short term, putting pressure on institutional investors trying to manage liabilities, especially where they are already cashflow negative. Over the longer term, the inflationary outlook is far from clear, however. The path to Brexit remains uncertain, but could prove decisive.
Institutions will face a tough decision on whether to hedge inflation risk despite significantly higher costs, or look through the short-term pain in the hope of lower inflation in the long term. Whichever way that goes, interest rates are unlikely to bring much relief in the short to medium term.
Inflation expectations appeared to take a sharp upward trajectory during the summer as Britain surprisingly voted to leave the European Union. Recent months have seen a significant increase in the cost of inflation protection as implied by the differential between nominal and inflation-linked gilts. More demand for inflation-linked bonds means a greater premium on those assets, which has driven the differential out roughly 0.5% over the last few months. Investors choosing to hedge at today’s levels would be paying that extra differential annually for decades, which would have a massive compounding effect.