Rising food and energy prices are leading some to argue that inflation targets need to be relaxed. But Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, believes that would be a big mistake.

ôThe 1970s experience tells us that allowing higher inflation to become entrenched will lead to more, not less, economic pain,ö says Sydney-based Oliver. ôSustained high inflation would be bad news for investors. The boost to investment market valuations from the move to low inflation that drove strong investment returns in the last 25 years would reverse.ö

Setting inflation targets and charging the central bank with achieving them has been best practice since the early 1990s. It was first introduced as a way of anchoring inflation expectations so that if there is a price shock û such as a sharp rise in food or fuel prices û it doesnÆt set off a self perpetuating wage price spiral like in the 1970s.

New Zealand was the first to have a target but now many countries have them. Both the European Central Bank and the US Federal Reserve target inflation below or close to 2%, although the FedÆs target is not formalised.

Over the last 15 years, inflation has been low in most countries.

After such a long run of low inflation and benign economic conditions, it is natural to forget the pain that out of control inflation can cause, Oliver notes. In the current environment, some see allowing a little bit of extra inflation as a good thing, as a way of avoiding the higher unemployment that might result if efforts to manage it continue.

ôThis is exactly what was thought in the late 1960s and early to mid 1970s, but the result was disaster,ö Oliver says.

Since inflation leads to higher nominal growth, particularly faster wages growth, it may seem good at first but it is ultimately bad, Oliver notes. Relaxing inflation targets reduces the value of cash. As a result, high inflation results in an incentive to spend and hoard rather than save and produce. It leads to higher interest rates as savers demand a higher return to compensate for inflation.

The 1980s highlighted that average interest rates rise even more than the rise in inflation because in a high inflation world savers and lenders require compensation for the extra uncertainty caused by high inflation. So rather than just the current cyclical rise in interest rates, borrowers would have to pay even more on a sustained basis if inflation was allowed to stay high.

Oliver adds that the recessions of the early 1980s and early 1990s highlight that once inflation gets out of control it can be very costly to get it back under control.

Beyond short-term cyclical fluctuations, the trend in inflation has been the single biggest influence on investment returns since the early 1970s, Oliver says. The combination of rising interest rates (which pushes up bond yields and pushes down equity price-to-earnings multiples), poor productivity growth, spiralling wages and the poor quality of company profits made the 1970s the worst decade for shares last century and the third worst decade for bonds, he notes.