Gareth Howlett: Gilt complex is no excuse for failure to spot inflation surge

WOULD you like to lend money to the government? Both your interest payments and your capital are secure, but the interest rate is below the rate of inflation and when the government does pay you back you will get less money out than you put in today.

You might not find this a very appealing prospect. There is only one UK government gilt on which you will make a capital gain, and you will have to wait 50 years for it.

When I was a lad and studying for my investment exams, gilts mostly traded at a discount to their redemption value, such that you would receive both an income and a tax-free capital gain at the end of the period. Looking back, this seemed a great idea. However, inflation and interest rates were higher then than they are today and in real terms the return was often better elsewhere.

Today, we are faced with similar problems. The great debate today is whether we face inflation or are sliding into deflation. Ask our govermment what the inflation rate is and it will tell you 3.2 per cent, but ask the person in your house who does the shopping and pays transport costs and they will tell you it is a lot higher.

Using the retail prices index measure of inflation means that 100 last year is worth 95 this year. There are many reasons why inflation is higher than expected - petrol, food prices and the weakness of sterling are all contributors - leading the government to tell us it is as it expected. However, a look at the Bank of England's website, which shows a prediction of inflation, demonstrates that this latest surge has in fact caught the government unawares.

In fact the same website has a game called "The Monetary Policy Balloon" where you can attempt to steer a course of 2 per cent inflation and, using the computer keys, either inflate or deflate the balloon to maintain course.

I am not suggesting for a moment that this is how Mervyn King and his colleagues on the MPC determine our fate, but it might explain why they have been so wrong so far! I scored 47 per cent and so am very unlikely to be the next Governor of the Bank of England, but I suspect I already knew that.

If you believe inflation will continue to mildly surprise on the upside, then holding gilts for a guaranteed capital loss and a negative real return makes little sense for the private investor.

However, if, as some believe, we are staring into a period of deflation, bond yields could have further to fall. The sovereign debt crisis in Europe continues to be a concern and to deal with this situation our Western leaders have found a new toy to play with. Called Austerity, this game involves tax rises and aggressive spending cuts but if they are not careful it might not reduce our debt, but instead reduce activity which in turn reduces growth and consequently increases our need to borrow again.Cue, let's print some more money.

At some point one has to come off the fence. We believe there will be short periods where markets will fret over deflation and holding gilts will benefit investors, but overall we believe inflation will be more persistent than the authorities lead us to believe and so see little point lending money to our government for them to repay us with less.

The whole purpose of investment is to make us better off in real terms, and the only gilts which make an explicit promise to do that are index-linkers. The index-linked tortoise will eventually overtake the conventional hare.

•Gareth Howlett is a fund manager director with Brooks Macdonald Asset Management.