How higher interest rates could transform our retirement

Central banks on both sides of the Atlantic are remembering that it is far easier to let inflation out of the bag than to stuff it back in again. The long-awaited interest rate pivot keeps being kicked down the road as the last mile back to the inflation target proves to be the hardest part of the journey.

The European Central Bank may well get things going with a quarter point cut next week. Christine Lagarde has said there’s a high likelihood that Europe will be the first out of the blocks. But neither the Federal Reserve nor the Bank of England would seem to be in much of a hurry to follow suit. The Fed may only cut once this year or even hold fire until 2025.

Here in the UK, inflation has come within a whisker of hitting the Bank’s 2% target. But investors were unimpressed when they looked beneath the 2.3% headline figure at persistent wage gains and service sector price rises. In the US, the Fed’s preferred measure - the personal consumption expenditures index - is expected to have stalled at 2.7% when it’s unveiled tomorrow, while the headline CPI was also flat at 3.4%, still some way above where the Fed would like to see it.

The concern of central bankers is that they might be bumped into cutting interest rates by what turns out to be a temporary return to target before stickier underlying inflation returns later in the year. There’s plenty of precedent here. In the 1970s, the second wave of inflation was more painful than the first as central banks let down their guard prematurely.

This time around there are plenty of new reasons to err on the side of caution. At least three of five key inflationary trends were not an issue 50 years ago. The first of these is the world’s rapidly ageing population as fertility rates decline almost everywhere. Japan demonstrates that poor demographics need not always trigger inflation, but it may be the exception that proves the rule. Other things being equal, more older people spending their money, with fewer younger ones working and earning it, is an inflationary mix. Shrinking workforces in much of the rich world look certain to lead to labour shortages and higher wages.

A second trend that didn’t exist in the 1970s is the deglobalisation that has reversed the closer integration of the 30 years from the fall of the Iron Curtain in 1989 to the arrival of Covid in 2019. The fracturing of global supply chains, exacerbated post-pandemic by the war in Ukraine and the souring of US-Chinese relations, has encouraged companies to think local. We didn’t realise what we’d got ‘til it was gone.

Turning our backs on the global village is the cause of a third inflationary trend, the revival of military spending. Just as the immense cost of waging the Vietnam War stoked inflation in the US in the 1960s and 1970s, the need to bolster our defences in Europe - perhaps with less support from the US after November’s election - will push prices higher over time.

Inflationary force number four was not even on the radar in the 1970s. The move towards a net zero world will be eye-wateringly expensive. As I’ve pointed out here recently, it is already showing up in the price of copper, a key metal for the energy transition, which is being squeezed between sharply rising demand and inadequate supply, after years of underinvestment. Hedge fund manager Pierre Andurand’s recent forecast of a quadrupling of the copper price to $40,000 within a few years was provocative but not implausible.

A fifth driver of future inflation is the financial incontinence of governments the world over, but most notably in Washington, where both candidates in this year’s Presidential election are unafraid of the big fiscal cheque. The US is set to spend 6% more than it is taking in via taxes. That is unsustainable, and it goes some way to explaining why the US economy has been so resilient in the face of higher interest rates.

Governments, as it happens, are among the biggest beneficiaries of persistently higher inflation. National debt burdens have ballooned in recent years, first in the aftermath of the financial crisis and then during Covid. That alone triggered spending worth 10% of GDP. Then along came the energy crisis in the wake of Russia’s invasion of Ukraine. Six G7 countries have gross debts worth more than the size of their economic output.

The only ways to get on top of those borrowings, other than allowing inflation to overshoot, are above-average growth, higher taxes, or lower spending. Growth is hard to come by; the other two are politically unacceptable. Governments won’t admit it, but they might welcome 4% becoming the new 2%.

The trouble for the rest of us is that 4% inflation completely changes the arithmetic of our retirements. It might not seem much of a difference but the impact on investment returns over longer periods is huge. Pension savings are always running hard just to stand still. At 2% inflation, a £1m retirement pot is worth £820,000 after 10 years and just £660,000 at 4%.

Most people would hope to be retired for a lot longer than a decade. After 30 years, that same £1m pension pot is worth £550,000 at 2% inflation and just £290,000 at 4%. It’s the unsentimental reality of the Rule of 72. Divide the inflation rate into 72 and the answer is the number of years it takes to halve your purchasing power.