Inflation Blog Series (4/5) | Today & Tomorrow
Many of today’s policymakers are too young to have lived through a time of double-digit inflation. Below are some recollections from someone who has, including:
Why the forecasters all got it wrong last year.
Why inflation was believed to be dead and why it might not be.
Whether some of the trends have permanently changed; and
Looking forward to the year ahead and beyond
A little over a year ago I decided to write a series of articles on periods of high inflation in history. The first article looked at the period just after the Black Death (1348), when shortage of labour caused an inflationary spiral. Next came the Tudors and Stuarts, then Germany after its defeat in the First World War. This was the most extreme period of price inflation in recorded history, when a cup of coffee could double in price in the time between ordering and paying for it, and workers took their week’s wages home in wheelbarrows.
I planned to continue the series with an article on the inflationary 1970s, a period which my generation remembers well, as we were young adults at the time, ending with an analysis of the inflation we are experiencing today, looking at its possible causes and whether it might persist, or turn out to be a mere blip as economic commentators and central bankers were unanimously predicting less than a year ago.
Then events overtook me. Inflation and the cost-of-living crisis has taken centre stage, eclipsing in the UK media even Covid, the Ukraine war, and the astonishing debut of Erling Haaland (although the sad news of Queen Elizabeth’s death is understandably currently the focus of UK news). In recent weeks it has been impossible to tune into any news medium without hearing about inflation and the cost-of-living crisis which it has precipitated. Strikes by public sector staff (railway workers, postal workers, refuse collectors with others threatening action) are already taking place and are the direct result of the fact that inflation is running at over 10% and wages have nowhere near caught up. Expert opinion tells workers to expect an even higher rate of inflation next year. If inflation is 10%, and the pay offer is 4.0%, then workers are being asked to take a 6.0% cut in the value of goods and services their income can obtain, with further erosion expected. If bosses say they can’t satisfy the natural desire to avoid an effective pay cut, this leaves no alternative but strike action. Overnight, we seem to have returned to the 1970s.
This time last year, I thought that the monetary authorities and commentators were being too complacent about inflation being transitory as I suspected that this incipient bout of inflation might turn out to be more serious and persistent than anything we have experienced in the last few decades. To be fair to them, no one knew at the time (late summer/early autumn 2021) that Russia would invade Ukraine causing chaos in world oil and gas markets. We will never know what inflation would be today had the invasion not taken place. However, my sense is that inflation would in any case be significantly higher now than it was a year ago. The invasion only added fuel to a fire that was already well alight.
In this article I’d like to return to last year and look at the reasons why economists believed that inflation was dead and could only return for short periods in exceptional circumstances, whether those reasons were valid at the time, and if so, whether they are still valid now. Then I’d like to hazard a guess at where inflation might go from here, if only to provide an opportunity to be able to look back in a year’s time and understand why I got things so wrong today!
Inflation in the 1970s was triggered by two oil shocks, one in 1973 and the other in 1979. The first happened when the forerunner of OPEC imposed an oil embargo on nations, including the US and UK, that had supported Israel in the Yom Kippur war. The price of oil quadrupled from $3 to $12 per barrel (compared to $100 today). Western economies were more manufacturing-based then than now, so the higher oil price affected economic activity more directly. These events took place nearly fifty years ago, and though I remember the time clearly, I keep having to remind myself that to have been financially affected by the inflationary 70’s – the last period of serious inflation in the rich world – you need to be over 60 years old, which many current commentators and decision-makers are not.
The reality of inflation was brought home to me one day in 1974. At the time I was living in college accommodation above a newsagent’s shop in King’s Parade, Cambridge. Returning to my room to do some revision for my finals, I popped into the shop to buy a Mars Bar. This bar had three stickers on it. The first one said 4p (the new decimal currency had been introduced in 1971). Above that had been placed another sticker saying 4.5p, with a third, saying 5p, above that. I paid 5p, 25% more than when the bar had been placed on the shelf. King’s Parade is a busy street, always full of tourists visiting the world-famous Kings College Chapel. My Mars Bar had probably been there no more than a few days.
It seemed obvious in the 70s that you should buy whatever you needed as soon as possible before its price went up. The complementary belief was that you should borrow as much money as possible because, with inflation hovering around 20%, the real value of your debt would quickly go down. You would be paying interest at perhaps 16%, which, though painful at first, would soon become manageable as your income would rise (you hoped) at somewhere near the rate of inflation.
The fall in the value of money caused savers to look round for hard assets to invest in, and their eyes fell on gold. There was a mania for kruggerrands, South African gold coins, which were advertised in all the papers. My father was tempted by kruggerrands, but being a natural sceptic, decided against. One day in 1978 I visited a jewellers’ shop in Carmarthen (I had by this time become a sheep farmer near Llandovery) to collect my watch which he’d mended. The jeweller told me that the prices of the gold and silver in his shop were rising so fast that he had a good mind to close the shop altogether as his counter trade was worth only a fraction of the gains on his assets. It’s just as well he didn’t, though, as the price of gold peaked less than two years later and went on falling for twenty years afterwards.
That year I started working for a company called Taylors of Welwyn, who made beehives. Early the following year, having just published our 1979 catalogue, we put through a 15% price rise across all our products. Later we were awarded a 22% pay rise, despite not being unionised.
All these things seemed perfectly normal at the time.
In the early 1980s inflation and interest rates subsided to a level we would recognise today, and have stayed at low levels apart from a brief aberration in the late 80’s. The early 90s recession killed inflation, seemingly once and for all.
The experience of those years left me with a real sense of the difference between ‘it hasn’t happened for a long time’ and ‘it couldn’t happen again’.
Why inflation wouldn’t come back (or so they thought)
The main reasons why experts believed that inflation wouldn’t return, as recently as last year, were globalisation together with ‘the three D’s’ – debt, demographics, and data.
Globalisation and particularly the rise of China, had kept prices low for decades. In the greatest migration in history, around a third of China’s 1.4 billion people left their small farms and headed for the cities, where they were prepared to work for wages which, while seeming pitiful to us, were life-changing for them. Gradually the quality of China’s manufactured products improved and one by one industries in the West found themselves unable to compete. It was said that China exported deflation – everything you could buy from the Chinese would cost vastly less than what you were paying before. The West duly migrated the bulk of its manufacturing to China.
This process has evolved considerably in the thirty years since the first Chinese shoes made their appearance in the US. Chinese workers have successfully achieved more than a tenfold increase in wages combined with shorter hours, and the move from the countryside to the cities has slowed. Recently manufacture has cascaded from China into cheaper areas such as Thailand and Vietnam. Meanwhile the political situation has deteriorated, as China’s rulers have become less business-friendly and relations between China and the West have turned frostier, and the cost of transport is also rising. There are still cheap relatively low-risk countries in which to set up manufacturing, but the great inflation-busting era of globalisation appears to have come and gone.
It has been argued that the world has become so indebted that most spare money is consumed in interest payments, leaving little to generate the kind of robust growth which could lead to inflation. The world is indeed more indebted today than ever – at the end of 2021 global debt had risen to a new record of $300 trillion or $37,500 for every person alive.
Borrowers pay interest to their lenders though, and the money is therefore transferred rather than disappearing from the economy. Interest payments only suppress economic activity if the borrowers would have spent the money they pay in interest, and the lenders who receive the interest don’t spend it. This won’t always be the case of course. If the lender is a bank, as it often is, it will use its income to pay employees and shareholders, who will probably spend it.
The main disadvantage of debt is that its burden always falls heaviest on poor people and poor countries. High levels of indebtedness tend to increase inequality, already a glaring social issue.
For the UK government, with its roughly £2 trillion of debt, high inflation will be a mixed blessing. 10% annual inflation knocks a massive £200bn hole in the real value of government debt, an amount equivalent to putting income tax up by 30p in the pound. But the quarter of UK government debt that’s linked to inflation will still rise in value as inflation goes up, and cost more money to service, partly offsetting the inflation windfall.
Inflation increases the government’s income. As salaries rise, income tax and National Insurance payments rise, all windfall income for the Government unless unemployment rises high enough to offset it, and as prices rise VAT on goods rises – unless spending on goods falls so much as to offset the windfall. Meanwhile there is pressure on the government to increase its social spending – and in today’s world, defence spending will rise too. It’s assumed that prolonged inflation will lead to a deterioration in the UK government’s finances. This may well be right, but the sum is complex and it’s possible that some fiscal headroom may appear.
The generally agreed rule is that older people save and invest, which is deflationary, while younger people borrow and spend, which is inflationary, so the effect of the rising average age of populations in the West tends to be deflationary overall. It’s also true that inflation changes behaviour. The prevalent idea of the 70s, that you need to buy what you want today before it goes up in price tomorrow may become the accepted norm again, accelerating spending by old as well as young. Inflation could increase the rate of wealth transfer from the older to the younger generation.
The pattern of ‘excess deaths’ has continued since the peak of the pandemic eighteen months ago. Actual deaths have been running at around 50,000 a year above predicted deaths over the last few months. The 6.7m people currently waiting for treatment on the NHS may not all still be alive by the time the NHS gets round to seeing them, and their currently routine conditions may have become life-threatening by then. It’s possible that the long, seemingly inexorable rise in life expectancy may have peaked, at least for the time being, which might be a factor reducing the deflationary effect of us elderly misers.
Technology increases productivity, and that reduces inflation. Moore’s Law, which dates from 1965, was the observation that computer processing power doubled roughly every two years. That process continues today, though at a slower pace. Computers do much that used to be done by people but computers do it much faster and more accurately. As they grow more powerful, they also get cheaper. The smart phone you could buy today may not cost less money than the one you could have bought a year ago, but it will contain features that weren’t available then. If today’s phone had been available a year ago, it would have cost more than today, so on a like-for like basis the price has dropped, as you are buying a more sophisticated piece of equipment for the same money. This is a small element in the inflation calculation, but difficult to capture in the numbers, meaning that headline inflation always tends to be a little overstated.
For many years the fact that inflation ran at much lower levels than those targeted by central banks was explained by a combination of the above factors – globalisation, indebtedness, ageing populations, and the advance of technology – however as I have outlined above some of these trends are now slowing down or reversing. Meanwhile the world population, due to exceed eight billion later this year, has continued to grow, and this growth has not been matched by a corresponding reduction in per capita demand. The aggregate growth of demand is inflationary as it results in increased demand for finite commodities. Technology can fulfil many of our needs, but it can’t easily make the soil healthier or more productive and it can’t increase the supply of raw materials needed to build infrastructure or electric cars. If inflation was ever going to return, it was always going to be led by commodities – and that’s just what has happened. The deflationary benefits of globalisation have been fading for some years now, a this is a trend which began long before Russia invaded Ukraine.
Where we are now
Forecasters today are falling over each other to predict ever higher inflation numbers. The most recent prediction (22% inflation this time next year) was issued by investment bank Goldman Sachs on August 31st. I’m sure it won’t be long before someone comes out with an even higher figure.
It’s worth pausing for a moment to remember what would have to happen for inflation to be 22% in August 2023. The inflation figure is very simple and rather crude – calculated monthly, it looks at the most recent price of a basket of goods and services compared to the price of the same basket a year earlier. It’s nothing more complicated than that. Every month, a new month’s data comes into the calculation, and the earliest month’s data falls out. Inflation is 10% now because prices are 10% higher than they were a year ago. By this time next year, last year’s data will have dropped out of the calculation, so for inflation to be 22% in a year’s time, prices would have had to go up by another 22% from where they are now. The chance of inflation rising by 22% in the next year seems extremely low to me but before explaining why, I’d like to mention the reasons why economists now think that inflation has transitioned to a permanently higher trajectory, as discussed in late August at the Jackson Hole conference of central bankers and reported in the Economist. These are as follows:
Government spending and borrowing patterns appear to have changed as seen during the pandemic, where governments were prepared to do whatever it took, regardless of cost, to soften the blow dealt by lockdown to their economies. Academics have calculated that the US government’s $1.9trn stimulus package has raised inflation by around 4.0%. In the UK, new Prime Minister Liz Truss argued for doing whatever it took to tackle the cost-of-living crisis and announced an ‘Energy Price Guarantee’ within days of taking office. Rishi Sunak argued that to do so would heap coals onto the inflationary fire, fatally weaken the Government’s finances, and frighten the global institutions who finance the UK’s public debt but lost the argument amongst party members.
Scarcity of workers caused by lower birth rates, the withdrawal of large numbers of people from the labour market during the pandemic, and in the UK’s case the departure of around a million EU workers following Brexit. Readers of my previous piece on inflation (Inflation 1) will recall that a shortage of workers was also the main inflation driver in the period after the Black Death.
The slowdown/reversal of globalisation and growing protectionism. This established trend is unlikely to reverse while global tensions remain as elevated as at present.
The counterarguments against permanently higher inflation were:
As before, one of the three D’s, demographics – ageing people tend to save – which is counter-inflationary
Potential productivity gains emerging from the stressful conditions of the pandemic.
Central bankers now believe that they are more responsible than their fathers, ‘owning’ the anti-inflation narrative more than of old. You may feel reassured that the good old central bankers have your back, but I personally wouldn’t get my hopes up too high on that one.
While on the subject of monetary policy, central bankers have been heavily criticised for failing to raise interest rates sooner to counter rising inflation. It’s said that they have been ‘behind the curve’. But is this criticism justified? Inflation can arise in different ways. In the classic economic cycle, there comes a point at the top of the boom where everyone feels confident and is over-spending. Companies are borrowing to build and over-paying to acquire other companies. Households are splashing out on home improvements, borrowing against their houses to do so, and perhaps taking a bit extra to fund the holiday of a lifetime. The economy is working above capacity and demand exceeds supply, so prices rise. It makes perfect sense for central banks to raise interest rates at this juncture, taking the heat out of the economy and bringing it back onto an even keel, sometimes by way of a recession.
But today’s inflation is not primarily of this type. It is caused by externalities – by global events pushing up the prices of energy and food, and by the weakness of the pound sterling, which makes all imported goods more expensive. This type of inflation acts as a tax on the consumers of those products. Central banks are raising interest rates – another tax on consumers – in a bid to curb inflation. This would appear to me to be an attempt to offset the effects of a series of factors which have put pressure on incomes by putting further pressure on incomes.
There will almost certainly be a period of economic contraction – a recession – over the coming autumn and winter, which may already have begun. Everyone is concerned at what lies ahead, and spending patterns are being adjusted accordingly. House prices, in a strongly rising trend since the pandemic, are cooling and the number of transactions are falling, and all this before the effect of higher interest rates has been fully felt in the real economy.
Against this backdrop, it’s hard to see what is going to cause inflation – too much money chasing too few goods – to rise by a further 22% over the coming year. The key variable of course is the price of gas, which Russia will continue to manipulate in such a way as to cause the maximum disruption to European economies. The wholesale price of gas is already at unprecedented levels and is expected to rise further. Just as the Russians have learned to live with sanctions, so the West will somehow have to learn to live without Russian gas. Demand for most other goods and services will be sluggish at best, making it harder to force price rises through. It’s said that the best cure for inflation is inflation. Higher prices reduce demand, lower demand reduces prices.
Over the next couple of decades, it seems likely that inflation will be higher than it has been over the last couple of decades, for the reasons given by the economists at Jackson Hole, and more generally because the world’s population and world demand continue to increase, while many of the world’s resources do not.
It seems that forecasters, anxious to avoid the mistake they made last year of failing to take inflation seriously enough, are erring now in the opposite direction, competing to predict ever higher rates a year ahead. One might say that they are in fact making the same mistake as they made last year, that of assuming that the current trend will continue, in the absence of any reason why it would.
In the short term, I believe we are in the middle of a painful inflationary spike. Taking all factors together, my guess is that inflation will continue on an upward path for the next few months and will then drop sharply during the winter and spring. In a year’s time the headline figure might be in the region of 0 – 5%. You are of course welcome to remind me of this prediction.
My earlier ventures into economic history suggest that patterns in inflation recur. In Tudor England the prices of food and fuel rose faster than anything else. The poor, who spent more of their income on these essentials than their wealthier neighbours, suffered most. Re-reading my article (Inflation 2), I was struck by this sentence ‘Sixteenth century inflation increased the returns to capital while reducing real wages and increased inequality in an already unequal society’. We see the same patterns today[i] and that’s why measures to tackle fuel poverty should be aimed at those who really need support (affordable) rather than indiscriminately distributed to one and all (unaffordable).
My next article will be about Russia’s invasion of Ukraine and its potential long-term effects.
Please note, these views represent the opinions of Tony Yarrow and do not constitute investment advice. This document is not intended as a recommendation to invest in any particular asset class, security or strategy. The information provided is for educational purposes only and should not be relied upon as a recommendation to buy or sell securities. Wise Investment is authorised and regulated by the Financial Conduct Authority, number 230553.
[i] You could justifiably argue that we haven’t exactly been seeing increased returns to capital over the last few months, in fact the exact opposite. In 1974, the stock market collapsed following the first inflationary shock, then rebounded in 1975 and continued performing strongly in nominal (though not always in inflation-adjusted) terms for the rest of the decade. I would not be surprised to see a similar pattern in this cycle too. In the stock market we are seeing the initial period of weakness now, but historically shares have always been a good inflation hedge.
Commercial property is a good inflation hedge too, as rents tend to rise with inflation and valuations generally follow.
Fixed interest is a poor investment in inflationary times. The almost halving in value of the Treasury 4.0% 2060 issue over the last year is capital irrevocably lost for investors in that issue, a belated acceptance by the market of the complete mispricing of government debt, which had persisted for a decade. It won’t get better while inflation stays anywhere near current levels.