GLOBAL/UK - Pension funds and other institutional investors, particularly those with inflation-linked liabilities, have been advised by Watson Wyatt to plan ahead for a return to high inflation, even though suitable investments could in some cases prove expensive.

In a report on world inflation, the consultancy firm's global investment committee admitted that accurately timing protection strategies against rising inflation would be difficult because the impact of varying factors could make it volatile.

Watson Wyatt suggested inflation is likely to stay low for several years - because of the weak global economic recovery - before increasing significantly in the medium to long-term. But it warned potential downside risks include a further economic or political crisis that reduces economic activity and maintain deflationary pressure. And this could lead to inflation rates in some areas of close to zero.

Robert Brown, chairman of the global investment committee at Watson Wyatt, added: "When inflationary pressures do return we are somewhat sceptical that central banks can smoothly manage an exit from the monetary policy response, and could fail to adequately control the inflationary pressures that emerge. In addition, if developed economies recover robustly and credit creation returns, inflationary pressures will emerge faster than we expect."

Within the report, Watson Wyatt indicated that it believes headline inflation will increase in the next year as 'index base effects' and energy prices "begin to feed through". The base effect is an unusually large change in the inflation rate between a 'base' date and a future date because commodity prices were abnormally high or low on the base date.

To prepare for this, Brown recommended: "Investors should be assessing its potential impact and planning timely protection strategies, particularly those institutional investors with large inflation-linked liabilities. These [strategies] could include hedging strategies using inflation-linked physical bonds or swaps."

Watson Wyatt predicted the increase in the headline inflation rate would be a "temporary effect" as inflation would be pushed down by "relatively weak economic fundamentals". Brown also noted that the firm's central view is "relatively high inflation of between 3% and 4% per annum will return after three or more years".

The findings of the Watson Wyatt report followed a call from pension funds last week for more long-dated and index-linked gilts to be issued by the government. Figures from the NAPF annual survey showed 82% supported the idea of increased issuance of these bonds, and Joanne Segars, chief executive of the NAPF, argued the measure would help reduce scheme deficits and support scheme sponsors by reducing the liabilities appearing on the balance sheet. (See earlier IPE article: UK pension funds demand more long-dated bond issuance)

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