The perils of launching QE2 - UPDATED

Barnett Waddingham’s Tickle believes there should be caution when using commodities as an inflation hedge. “Commodities only protect against a certain form of inflation, for example against cost-push inflation (where rising prices are the end result following increases in the costs of inputs into the production process) – for other causes of inflation the linkage is more arguable. Is it a good protection against the currency debasement we’ve got going on at the moment? I think the jury is still out on this.”

He then goes on to add that there is always a difficulty in understanding the correlation versus causation argument. For instance, does the fact that commodity prices and inflation are rising together mean they are a good hedge for each other. “I don’t think the relationship is as strong as that. That said, it is a real asset, so over the long term it is not a terrible hedge, but it’s not as perfect as some people might say,” he adds.

The biggest problem trustees have with these situations is reacting in time. It should already be a priority for trustee boards to discuss the effects of quantitative easing. Timely decision-making is advantageous in these sorts of situations. Considering inflation when it has crept up to 4% is a little too late.

“Having a plan in place to do something at the next opportunity is right thing to do,” says SEI head of European institutional solutions Ashish Kapur. “The most recent example is that inflation has not just risen or become an issue in the last few months. It has been creeping up almost for the last few years. So each time this happens we’ve been having discussions with people. These discussions should have been happening much earlier – inflation is an expensive hedge right now for schemes reeling from the impact of falling funding levels of the last few weeks.”

The spectre of deflation

While high-inflation presents a number of problems, these can be adequately controlled and hedged if they are done in a timely fashion. The risk of deflation is far more worrying for pension schemes. A period of sustained deflation will lower the value of pension scheme assets, and while schemes have caps in place against high inflation, many do not have controls in place to lower payments if there is a sustained period of deflation. This would make it excruciatingly difficult for schemes to manage their liabilities.

There are some pointing out that the UK could eventually be caught in a deflation conundrum similar to Japan. For a number of years Japan had endless spirals of deflation and could do nothing to escape. Meidar, however, feels the parallels between Japan and the UK are limited: “There are few good analogies out there between the two countries. We don’t have the same demographic issues as Japan and we have a very different political environment.”

But even if we do not suffer the same fate as Japan, Matt Tickle believes there is always the risk of deflation after a banking crisis, and the subsequent de-leveraging after this has added to the risk. However, he views US-fed policy as the surest sign we will not see deflation.

“The reason we don’t see this as what is going to happen is the old adage ‘you don’t fight the Fed’,” says Tickle. “Bernanke has said ‘no deflation on my watch’, and his actions are following his words. Other policymakers have also said ‘no we are not having deflation’ given the government debt situation. So it comes back to the view of whether you think they can fight it. I think they are throwing enough at it to stop deflation.

It would seem the only option available to the Bank of England is to follow the Fed and start a new phase of quantitative easing to avoid deflation. The difficulties schemes will experience because of high inflation could be simple compared to the conditions that deflation will bring. For many trustees and scheme managers, the knock-on inflation from quantitative easing could be better than the alternative.