Here we go again: it’s the unhappy return of inflation

Last year, when deflation was still seen as the bigger threat, advisers were urging investors to start thinking about the return of inflation.

Assurances by the Bank of England, among other authorities, that quantitative easing was fully under control, and that the exit from it would be as smooth as the entry, failed to calm nerves.

That may be because never in the history of monetary policy have central banks managed to get the notoriously delicate transition absolutely right.

Policy tends to either overshoot or undershoot, with very painful consequences that take months or even years to work through.

So the revelation that the UK inflation rate for December hit 2.9%, up from 1.9% in November 2009, shocked only the dozy or negligent.

The Bank of England's target rate is 2%. The year-end leap exceeded all expectations and was the biggest monthly rise in the annual rate since records began. Now the squirming begins. It was the 2009 VAT cut and hike that did it.

Or variable clothing or food costs. Or energy inputs. It is a temporary blip, a backwardlooking, lagging indicator, and anyway, we are nearly at the end of £200bn worth of quantitative easing (the tap gets turned off at the end of February), so let's just have a last blast of liquidity.

Besides, there is an election looming. Will the Bank of England now freeze its purchase of gilts in February and face off the vote-sensitive Treasury with the required rise from the 0.5% base rate?

It is clear that governor Mervyn King would like to. It would be a brave assertion of the much-vaunted independence of the Monetary Policy Committee.

But don't hold your breath. Consultants are starting to put numbers on the scale of the impact if pension funds fail to address potential inflation risk. Towers Perrin has said deficits of FTSE100 defined benefit pension schemes hit £72bn due to high inflation predictions.

Those deficits had increased despite recent market gains, which had been swallowed up by growing liabilities. Deficits on final-salary schemes of FTSE350 companies have rocketed from £60bn to £170bn in the past year, according to Mercer.

This is the biggest jump since it began tracking deficits in 2001. Liabilities rose from £440bn to £620bn during the same period, partly a result of expectations that long-term inflation will increase.

While the analytical tug of war between inflation and deflation existed, hard-pressed sponsors might have been debating whether to keep any spare cash on the company balance sheet or direct it to support pension schemes, where liabilities will be driven higher by future inflation rates.

Now they know, and it is time to act, even if the inflation threat is considered "medium term". Among protection strategies available are inflation-linked physical bonds or swaps.

Sponsors can also close schemes to future accruals and new members to cap liabilities, or switch (if they have not already) to less expensive defined contribution schemes.

Nordic pension plans, typically ahead of the game, have in the last year demonstrated strong interest in non-cyclical infrastructure investment, which offers risk diversification, stable predictable returns and a strong link to inflation.

Take-up is most among schemes already used to investing in other alternative asset classes like hedge funds and private equity. The final solution: shift pension liabilities altogether by paying an insurance company to take them via a buyout.

Caroline Allen is investment editor of Incisive Media's financial services division