There is much debate, not least amongst those responsible for monetary policy in different economies, whether the recent global increase in inflation will prove ‘transitory’. What exactly do people using that term think it means, or want it to mean to their audience?
Literally, they must mean that the increase will not persist: higher inflation will last for a short while and then fall back to a level closer to what we have recently experienced. It is not long-lasting, let alone permanent. This may be accurate but it is also misleading, because it confuses the effects of a change in the rate of inflation with a change in the price level. If the price level jumps, it has a permanent effect on living standards unless either i) prices fall back to where they were or ii) the nominal income streams on which living standards depend are well-enough indexed to inflation.
My guess is people mostly say ‘transitory’ because they think the rate of change will decelerate, not that the price level is undergoing a change that will reverse. To the extent it doesn’t reverse and their income is not indexed, the erosion of living standards is permanent, not transitory. For some people using the term, that might be something to disguise.
How does this play out for investors?
- Investing in assets whose returns are imperfectly indexed, but that show over long periods a positive real return trend (like equities and property), ‘transitory’ may be reasonably valid, as a description of the likely positive or negative deviations from real return trends – though the residuals can themselves trend for longer periods than ‘transitory’ implies.
- Investing in nominal instruments with no inflation protection, like conventional fixed-income bonds, the effect of an unreversed price increase is permanent, even if the rate of real capital erosion later decelerates. Nominal bonds have been referred to as ‘certificates of confiscation’, a term that rightly implies permanent loss.
- Less obvious, and more subject to cognitive errors, is where income is partially but not fully indexed to the general price level. I recently referred to a particularly tricky example: the capped inflation increases applying to the new terms imposed on British Steel pensioners if they chose to accept reduced benefits as an alternative to staying in a scheme that was then entering the Pension Protection Fund with similar but different caps on inflation protection. Both sets of caps create permanent, not transitory, effects if the price level does not fall back. The gaps opened against a fully-indexed income can quickly become highly significant. Over long periods they could cumulatively be as large as the real equity return risk.