Fears that inflation will return as a scourge of the UK economy may be understandable or may prove premature. Whatever happens, it is as well for investors to consider strategy in how to cope with any inflation, says Fidelity.

Here is a question that might have come from an examination paper on economics in a UK school: Which is the greatest threat to investors, inflation or deflation? It is a real dilemma facing investors today.

Inflation has, of course, risen and fallen throughout history; it is one of the many considerations for investors planning their portfolio. But today, investors find themselves at a rare crossroads where they simultaneously face an almost equal possibility of inflation and deflation.  

So what has caused this curious situation and what should investors do about it?

For a decade since the Bank of England took responsibility for setting rates, inflation was kept very close to the Bank’s target rate of 2 per cent. By 2006, heat in the global economy pushed the rate beyond 3 per cent and the [BoE] Governor was obliged to explain the rise in an open letter to the Chancellor [finance minister]. By 2008, the genie was out of the bottle and a rampant oil price had forced inflation to a peak of 5.5 per cent. At this time, investors were preparing themselves for a debilitating bout of inflation; for example, the price of gold, a traditional inflation-busting investment, doubled between 2005 and 2008 as investors sought protection.

But by the peak of inflation in 2008, the financial crisis had already begun and the global economy had cracked into today’s recession. Since that peak in September last year, inflation has dropped like a stone and now rests at 1 per cent. Prices are still rising, but only just. If the rate of decline continues, prices will actually begin to fall by the autumn. So the clear and present danger has swung within a year from inflation to become deflation.

It is this prospect that occupies the BoE and other rate-setting authorities across the world. Today’s loose monetary policy is their response and investors are now hunkered-down for a spell of deflation – inflation-linked bonds, for example are relatively cheap at the moment reflecting a general disinterest in insurance against rising prices.

The risk, however, of rate setters’ loose policy is that it might overcook the economy further out, causing a return to inflation as quickly as we left it. As remote as that prospect seems right now, quantitative easing on this scale is untested and completely uncalibrated. Who knows whether the £125 billion ($212 billion) so far poured into the UK economy by the Bank of England’s quantitative easing policy is too little or too much? The [BoE] Monetary Policy Committee has admitted as much by holding fire on further easing and adopting a “wait and see” approach at its July meeting. There is, therefore, a very good chance that the Bank and its peers take their foot off the gas too late and we launch into another period of uncomfortable price rises.

The key for investors now is to focus on what is known rather than attempting to anticipate uncertain future events. Today’s problem is slowing price rises and the near certainty of a (perhaps brief) period of deflation. Tomorrow’s problem might be inflation but this outcome is far from inevitable and centres on two main arguments.

First, it assumes the twin stimuli of low rates and additional money supply quickly filter down through the economy and are the catalyst to fresh activity. At the moment, this is not happening. There is a bottleneck at the banks as their requirement to reinforce their balance sheets by maintaining exceptionally profitable lending margins means, for example, a 0.5 per cent base rate translates into a 5 per cent fixed-rate mortgage deal. Also, because the crisis stalled industrial production, when demand does pick up there is the current excess capacity to be taken up before any upward pressure is applied to prices.

Second, a return to inflation relies in part on future monetary policy mistakes – in other words it would need rate setters to misjudge their exit strategy from today’s loose policy.

This does not mean to say investors should forget inflation altogether, but to be realistic about the likelihood, timing and impact of its return. To anticipate an immediate return to inflation on the theoretical basis that big central spending immediately hits prices would be an error. Equally, it would be a mistake to entrench a portfolio into a defensive, deflation strategy to find that it misses the early birds of any sustained economic recovery.

As is often the case during periods of uncertainty, a balance of investments decided upon by reliable analysis of the present and likely future scenario is appropriate. An ability to read the correct inflationary and deflationary signals as they change, and the flexibility to adapt your investment portfolio in response, is essential. Possession of these qualities should mean you pass this test with flying colours.