Volatile inflation post-GFC will force funds to consider hedging, said Watson Wyatt’s Robert Brown, chair of its global investment committee.

Institutional funds with large inflation-linked liabilities, for example defined benefit funds, should “revisit their exposure to inflation and consider hedging it where practical and cost-effective”.

Brown said that relatively high inflation of 3-4 per cent a year will return after three or more years and that Australia’s monetary policy action “will nonetheless be overwhelmed by global trends … leading to a higher than currently anticipated Australian inflation rate over the longer term”.

Watson Wyatt’s report, “What matters in global markets”, is published today and it acknowledges the market’s “relatively benign outlook” of 2.5 per cent, at the mid-point of the Reserve Bank’s target range of 2-3 per cent.

The Australian economy was not as badly affected by the GFC as other developed economies, and so interest rates could be raised if inflationary pressures to increase, said Brown.

An extreme outcome is the inflationary pressure which may build due to difficulties in financing current policy response, said Brown.

“Currently, it is the government, through both fiscal and monetary policies, this is underpinning economic activity — a situation which is expensive and likely to persist for longer than is comfortable,” said Brown.

“The consequent huge deficits will lead to very high bond issuance by developed world governments in coming years.”

http://www.watsonwyatt.com/asia-pacific/australia/research/what_matters_in_global_markets.asp