JUST three short months ago, the focus in financial markets was all about deflation. Commodity prices remained weak, inflation was turning negative in the euro area and European Central Bank president Mario Draghi conjured images of a “Japan-style” scenario.

Since then, inflation has started to offer some positive surprises. German consumer prices have picked up quickly. US core consumer price inflation has consistently come in stronger than had been expected.

Some economies still experience negative inflation, but this is the negative inflation of a relative price shift, not the deflation of a general price decline. Having falling oil prices, and all other prices rising, is a very different economic proposition from the across-the-board price decline that warrants the title “deflation”.

This shift to modestly higher inflation is largely a developed economy phenomenon. Inflation in these countries is generally dependent on domestic labour costs, and the tighter labour market in the US and more limited labour flexibility in Europe have helped keep these costs higher. No one is suggesting runaway inflation, but certainly, consumer prices seem to be moving higher.

The problem for investors is that financial markets are not terribly good at understanding inflation, and investors may find their future standard of living is unexpectedly damaged as a result of this misunderstanding. In some ways, this is somewhat surprising — inflation is hardly a novel concept.

We have almost three thousand years of inflation evidence. However, the lessons of inflation are often swiftly forgotten — dynasty after dynasty in medieval China collapsed amid hyperinflation, failing to learn the lessons of their predecessors. The 20th century is littered with instances of high inflation and hyperinflation — most of which were the result of avoidable policy errors.

If we are entering into a period of modestly increasing inflation (at least for prices away from commodities), what should investors be aware of? One important point is that the inflation, of itself, will do little to ease debt burdens. So much government spending is tied to the rate of inflation these days (up to 70% in some Organisation for Economic Co-operation and Development economies) that a rising inflation rate tends to make a government’s debt-to-GDP ratio worse, not better.

This means that governments are going to continue to engage in financial repression (forcing certain investors to buy bonds for “regulatory purposes”) as a subtle form of savings tax.

A second key point to bear in mind is that inflation is very rarely caused by foreigners. Around two-thirds of any country’s inflation can be directly attributed to domestic labour costs.

Think about how much domestic labour is added on to an imported good after it arrives in a country — the transport, marketing, storage and retailing of a product are all labour costs. Foreigners may have some impact but the impact pales in comparison to domestic labour costs.

Most important, perhaps, investors need to understand that the headline consumer price inflation that they read about is very unlikely to reflect the inflation rate that they experience.

Inflation inequality has been a key feature of the global economy in the recent past. This means that certain groups in society will face a higher inflation rate than other groups in society.

Generally speaking, the lower your income, the higher your inflation. In addition, the older you are, the higher your inflation. This is a lesson that, considered from the perspective of price inflation, one should try to be young and rich if one can possibly help it (economists rarely fulfil either of these qualifications).

This inflation inequality is important because it means that (for example) if an investor is trying to save for retirement, it is no good just beating the average consumer price inflation measure. The cost of living in retirement may well be rising faster than the average cost of living in an economy (medical bills are an obvious source of this discrepancy).

This means that some investment instruments, such as inflation-linked bonds, may actually provide less insurance against the future cost of living than investors might hope.

So as inflation creeps back onto the global agenda, however slowly and subtly, investors may need to start considering how best to guard against it.

It is important to understand what inflation actually is. Inflation is a simple concept — we all experience inflation, we all know what it means when prices are rising. However, inflation is not simplistic.

Inflation cannot be reduced to a single line on a chart and presented as the definitive change in the cost of living. Once investors understand that, then they can start to protect themselves from its consequences.

Paul Donovan is senior global economist at UBS Investment Bank. His latest book, The Truth About Inflation, was published by Routledge in April 2015.

This article first appeared in The Edge Malaysia Weekly, on April 27 - May 3, 2015.

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