And you thought the pandemic kept you up at night. A wave of high inflation is engulfing the UK economy, with January’s 5.5% CPI inflation measure the highest for 30 years.
Few will sleep easily as the cost of living soars.
It’s enough to send you back into social isolation to avoid paying higher prices:
Of course, an irony of high inflation is it can make it rational to spend now rather than battening down the hatches and saving for the future:
- If the prices of furniture or cars are going up so quickly, can you afford to put off a purchase?
- If the real terms spending power of your cash in the bank is getting eroded faster than a prince’s credibility, why save?
These are questions we haven’t had to think about for years.
At Monevator we believe you should still try to live within your means and pay yourself first. Investing in a range of assets is the best way to protect yourself against inflation in the long run.
But that’s not to downplay things – nor to forget that poorer households have few real assets and little option but to suck up higher prices on daily essentials, or go without.
Moreover in the UK things are nailed-on to get worse before they get better.
Energy bills will soon spike with the 54% increase in the regulatory price cap in April.
And while an imminent National Insurance increase won’t itself feed into inflation (and may even dampen spending) it all adds to the squeeze on our spending power.
Two factors behind high inflation
There’s a big debate as to why inflation is so high after decades mostly in the doldrums.
I skimped on it in my earlier quantitative tightening post, in the interests of time and space. (Yours and that article’s, not Albert Einstein’s…)
But let’s now get into it.
Beyond causing you to wince every time you reach the supermarket tills, high inflation is roiling the bond and stock markets.
Traders have scrambled to anticipate how and when Central Banks will raise rates in response.
This is hardly a no-brainer. Central Banks must try to choke off high inflation without strangling the post-Covid recovery.
And how they can best achieve that depends on what exactly is causing prices to rise so quickly.
There are two main theories:
- One side sees a supply shock. The pandemic plunged us in and out of lockdowns. Our shopping habits changed more than a five-year-old’s wishlist to Santa. Factories and distributors couldn’t cope. The result? Surges and gluts that have screwed the price of everything, from oil and lumber to used cars and gym equipment.
- The other side says it’s all about demand. Consumers have too much money. Their wallets were bloated by overly-generous government aid to offset Covid. Savings were fattened by all that time we were Zoom-ing in our undies instead of going out spending. Very low rates (and booming stock markets) have given everyone too much financial firepower.
For what it’s worth I’m mostly in the supply shock camp. (Though I must admit it’s getting lonelier.)
I expected huge disruptions from lockdowns, so I was not surprised by them. Listening to firms reporting their earnings, I’ve been hearing about problems up and down the supply chain. But these will be solved. And I see no reason why secular deflationary forces have gone away, longer-term.
To give just one illustration, the online furniture retailer Made saw its key Vietnamese suppliers shutdown when Covid overwhelmed that country last year. Made is now carrying tens of millions of pounds worth of deferred revenue on its books – and it’s a sure bet some would-be Made customers went elsewhere. Yet rivals faced the same issue. And some of their customers went to Made.
The net result is whatever stock retailers did have in could command a higher price. Especially as it has become very expensive to ship in replacement goods from Asia, with container rates increasing by as much as 800% last year. Discounting was reduced. Sales grew, but margins were crimped by higher costs.
This to me is all indicative of a supply kerfuffle.
Admittedly, some select companies are boasting of straight-up sky-high demand.
Disney is one. US customers seem willing to hurl money at the House of Mouse after two years cooped up with their kids. On a recent earnings call, its execs all but boasted of their ability to charge higher prices at Disney’s theme parks.
So I do see both forces at work.
In addition, demand shock advocates also note how the US government sent out money in the mail. They see a housing boom in the US, the UK, and elsewhere. They point to meme stock and crypto bubbles in the midst of the pandemic as indications of money to burn.
And then they wonder what us supply-siders are smoking?
Unusually abundant money has probably thrown fuel on the fire. But I’m not convinced it’s the cause of high inflation.
For one thing, the widely-fingered form of fiscal Covid support deployed in the US – universal stimulus cheques – wasn’t really done so much in Europe. But we’ve still got the high inflation.
As for easy money, near-zero interest rates didn’t cause high inflation before Covid – nor in Japan for many years before that.
So why now?
And the key forces that kept price rises low before Covid haven’t gone away either.
To return to my Made example, that company will continue to source from numerous global suppliers and undercut slower legacy businesses like John Lewis. Brexit has introduced more friction into UK trade, but it hasn’t turned off globalization.
Similarly, Made’s technology platform should continue to drive higher sales from a relatively smaller base of staff and premises than older firms can achieve. Some of this efficiency will be passed on to consumers as lower prices.
These wider trends (and others) have helped keep lid on inflation for decades. They are beyond the authorities’ control.
Why does it matter what’s causing high inflation?
If high inflation is mainly due too much money sloshing around – from interest rates kept too low for too long or from government super-spending – then rate rises are just the thing we need.
By raising interest rates, central bankers make it more expensive to borrow and more appealing to save. This pours cold water on the animal spirits of companies and households, taking some heat out of the economy.
Expansion looks riskier, so less of it happens. Interest charges on debt go up, meaning less money to spend on everything from factories (companies) to stuff (consumers).
But what if high inflation is mostly a supply chain issue, as I suspect?
In that case raising rates might not be so helpful.
Sure, rate rises will slow the economy, and reduce demand for what money can buy. That will mean less pressure on stretched supply chains, and less scope for companies to jack-up prices.
However higher interest rates don’t magically make supply chain problems go away. In fact they could inhibit some solutions – expansion at ports, say, or hiring more workers.
Thus raising rates could slow the economy without curbing inflation, at least for a while.
Which raises the spectre of stagflation – a stagnant economy in a death pact with high inflation.
Again we haven’t seen that for more than 40 years. And as 1970s revivals go, you’d rather get a mullet.
Higher wages could embed high inflation
Regardless of what caused this high inflation, the key issue will be whether central bankers can head off a wage spiral.
If workers expect prices to keep rising and are able to demand higher salaries, they will spend their extra earnings bidding up prices even more.
This is the stuff of nightmares for central bankers. I suspect it’s why the Fed is talking tougher than economic conditions really warrant. (I believe US growth will probably slow quite quickly from here).
The governor of the Bank of England got a kicking earlier this month for urging wage restraint. But we should understand where he’s coming from.
I’d be all for fat cat wages rising slowly and everyday workers’ earnings rising more quickly – in real terms – in a sustainable way over several decades.
But wages that quickly spiral to chase ever-escalating prices are no good to anyone. Again see the 1970s.
You can’t blame workers for wanting more money. High inflation means that even with eye-catching nominal wage rises, real (after-inflation) wages are falling:
Source: FT
The trouble is once wages go up they seldom go down. They are ‘sticky’, in the jargon.
Don’t believe me?
Imagine Apple cut the cost of iPhones by 20%.
That’d just be a Black Friday sale.
But what if Apple chopped salaries by the same amount?
It’d surely make global headlines.
Take a look at this graph from the Office for National Statistics:
Source: ONS
As you can see, worker incomes have grown at a positive – albeit slowing – clip for, well, ever.
Individual firms might go through retrenchments that give them more bargaining power with staff for a time. And there can be shenanigans at the margin (e.g. more part-time staff or fewer better-paid staff and more contractors). But salaries in aggregate go up and stay up, adding to the cost base and fueling higher prices, as companies try to maintain their margins.
People become accustomed to a certain lifestyle and they are loathe to give it up. If employers try to cut their wages, they’ll try find another job.
Very low unemployment makes that much easier.
Curb your enthusiasm
Twitter abounds with armchair economists screaming that central bankers should raise interest rates yesterday – as if the mandarins at the Bank of England and the US Federal Reserve haven’t noticed that inflation is running at twice their target rate.
These bankers know high inflation could well prove a blip – provided wages remain restrained.
Besides supply bottlenecks getting sorted out, there are technical reasons to expect inflation to calm down. Prices can leap, but provided they stop leaping they stop contributing to inflation. An oil price approaching $100 a barrel will continue to be painful, for instance, but it won’t keep boosting inflation year-over-year unless it goes above $100 and beyond.
Bankers also know that hiking rates will take a while to have any impact. We might only know they’ve raised them too much when the impact is felt alongside a slowing economy.
Finally, the cure for high prices is always high prices. Capitalism sorts out inflation by finding new sources of supply or by promoting substitute goods for profit, which curbs further price rises.
Many people will tell you it’s obvious how this will play out. They will point to current market forecasts of inflation expectations and rates, which imply this high inflation is transient and that interest rates will indeed rise for a bit, but should then will start falling in a few years.
I think that’s likely, but I don’t think it’s a slam-dunk.
Market forecasts always look highly rational at the time. But those curves weren’t predicting today’s inflation at 5.5% – nor markedly higher interest rates – a couple of years ago.
Far from it.
Great expectations
How this all shakes out is anyway highly relevant to us, both as consumers and as investors.
High inflation can increase the correlation of shares and bonds in the near-term. It’s bad for both, as they fall until they find a new level appropriate to the more inflationary environment.
That would leave the safety cushion element of a typical 60/40 portfolio looking rather deflated.
Longer-term, shares can benefit (high inflation can boost sales and profits, if only in nominal terms, bringing down those frothy valuations) but it won’t be such a smooth ride.
As always we everyday investors probably shouldn’t be making heroic bets in an attempt to outwit the multi-trillion dollar markets.
As I’ll discuss in my next post, a diversified portfolio is more not less important at times like these.
We may be in a new regime for inflation and rates, compared to the past 30 years.
But I see it as more as the equivalent of a new government than of a radical overnight coup.
The forces of deflation are in retreat, namely the China effect and the developed countries demographic issues.
From here on we can expect higher inflation than we have been use to and therefore higher interest rates as well.
A good book on the subject is the Great Demographic Reversal by Charles Goodheart.
I agree that supply side problems have dominated in causing inflation. I am not sure interest rate rises are going to have any effect – partly as a result of it not being demand side, and partly because their current level is low anyway. I think their lowering in 2009 was to defend the pound rather than for any domestic reason, but they have stuck at a low level. Logic would suggest that interest rates ought to be roughly similar to inflation – so a rise stimulates saving and a drop stimulates consumption – but it no longer seems to work like that. Probably the only people who save in cash accounts are those who are cautious anyway and don’t think about real terms values, and most people borrowing use credit cards with rates in excess of 20% where the odd quarter percent is hardly noticeable.
I didn’t comment on your previous blog on quantitative tightening, but I think QE was similarly about macro perceptions. It became a fashion in 2009 after it succeeded in saving share prices from plummeting as far as they might have done, and saving potential bankruptcies. Essentially by injecting money into the bond markets it supported other interchangeable assets: share prices, and to a greater extent than I would have expected property prices. The same strategy was pursued to deal with the economic risk of Covid.
Ironically that meant the Conservatives turned on the “magic money tree” they so much claimed to despise to create money. They feared it would drive inflation, and it did in stock and property prices (to the benefit of many here). But I don’t think it has been the driver of the general inflation we are seeing now (you can’t attribute gas prices to it for example) but it needs normalising. This one is even more difficult than getting interest rates back to sensible levels: there has resulted an expectation that investment assets will rise at much higher levels than justified (e.g. all those CAPE analyses) which means at the very least asset prices need to stagnate for a little while. The challenge will be to normalise both interest rates and money creation in a way which avoids the psychological effects of a nominal terms drop of asset values.
My bottom line is the same as yours, the next few years are going to be a bit bumpy.
Talking of inflation I received a notification of increase in my phone and broadband price today from Plusnet.
The increase is CPI inflation + 3.9%
My fault as I left it very late to renew and not only got stung with this contractual rise, but they wouldn’t give me a discount off the price as they previously had.
I will definitely be better organised for the coming renewal. A 4G mobile router and an unlimited mobile data plan from someone like Smarty look good. (Perhaps 5G will have arrived here by then – fingers crossed).
The only slightly good think I can think to say is that I have some old Index Linked National Saving Certificates, as part of my minimal risk holding, which I am hanging onto.
Thanks @TI – not sure there is a better, more thoughtful analysis of what’s happening anywhere at the moment
Geez. Its 5.5% inflation versus a target of 2%. Shock. Horror. Interest rates might rise to 2% in 2023!
I’m sleeping easy. Its all just background noise.
I tend to see this as primarily a supply bottleneck but localized demand effects are relevant too. The scale of the fiscal transfer in some countries, combined with wealth effects, is creating pockets of extreme demand.
The concern really is inflation expectations, not the high current levels of spot inflation. Spot inflation will fall back as long as expectations do not change. Hence the fear of a wage price spiral.
The 70s is a good example because wages grew 15-20% over the decade in real terms. It was a good time to be a worker … at least for a short while. The problem was those real wage gains were not associated with comparable productivity improvements. An already uncompetitive economy just became even more uncompetitive. We paid the price for that in the early 80s with a collapse in many industries and very high unemployment.
We are in a similar situation now, with an already expensive but low skill, low productivity workforce. So far wage increases have been strong but in only a very few localized sectors. As an economy we really need to eat the cost of living increases but I fear we won’t.
@ZX:
Whilst I am sure you are correct that “inflation expectations” will play a key role, this paper provides an interesting take on said expectations:
https://www.federalreserve.gov/econres/feds/why-do-we-think-that-inflation-expectations-matter-for-Inflation-and-should-we.htm
Very useful article, thanks. Current inflation levels are another reminder of how we have little idea of anything beyond the immediate future and hence the diversified portfolio is relevant as you say.
12 months ago, I felt inflation was unlikely, which proves my forecasting inability. I continue to think its likely to be more transitory than sticky and the Baltic Dry Index is suggesting some of the supply issues are becoming less stuck with higher prices likely to encourage increased supply over time.
I would bet the recent pay rises will more likely than not settle down over the next couple of years as the effects of the ‘great resignation’ filter out and price rises slowly dissipate.
Your comment in a previous article about cash quite possibly being the best place to be for the moment is also quite timely acknowledging the conflict with market timing. Most people understandably think cash is trash in this environment but its quite possible that it performs better than equities / conventional bonds in the short term, which historically don’t react well to these levels of inflation. Medium / long term equities have to be the place to be but that could potentially be a decade of going nowhere, who knows.
For the average UK person it’s another inevitable leg down in living standards I’m afraid with some real challenges for certain sections of society over the next few years. Like others have said, the UK needs to focus on productivity and ideally lowering the cost of living. Presumably no one does as it’s a very hard problem to crack. As a result one should expect some seriously upset people, which will likely manifest itself in some sub-optimal political policies largely focused on squeezing the readers of this website.
“Lumbar”?
Sorry, couldn’t help myself. It’s up there with “navel warfare” and World War 2 “Nissan huts”. Good article, and comments.
@Al Cam – you’ve got to love an economics paper that starts with Dashiell Hammett.
@David C — Oops. There typed someone with an on/off history of back pain! Fixed now, cheers!
Inflation is a monetary phenomenon in the sense that it can only happen if money supply increases outpace output (“GDP”) growth. Milton Friedman is one of very few economists you should really listen to.
The COVID fiscal measures are an example of this monetary phenomenon but it is likely just a one-time event (even more so given the current inflation “scare”).
The only other way (ignoring extreme measures such as true money printing) is via credit expansion. But the monetary system is not what it used to be back in the mid-late 20th century. Not only is the demand just not there any more, but the supply is hard to push given risk adverseness of the financial system (partly due to lack of quality collateral). It is why QE is seen (by the deluded financial “experts”) as not working – not that it is even a necessity for credit growth given banks are never reserve constraint but instead are capital/economic-motive constraint.
The 70s were a very different period to the one we are currently in. We saw demand for labor rise as the economy started to shift more towards services and a unique demographic situation where we had the baby boomer gen at prime working age creating massive demand for goods and services. That is why real wages rose along with inflation. Productivity growth was pretty good (certainly a lot better than now) with exception to a couple of nasty brief recessionary periods. Productivity had to have improved otherwise why on earth would companies raise wages so much?
With no signs of productivity improvements in current times (along with a lack of aggregate demand), the impetus for companies to hire at higher and higher wages is just not there anymore. Companies would sooner shut shop than run at a loss – with certain exceptions such as companies where it makes sense to do so and can be funded cheaply via equity (e.g. certain tech) – but these are really exceptions due to unique positioning and arguably add to the deflationary impact in the first place.
If it results in fewer people migrating to this country and more people migrating from it, then viewed from “the hill that I stand on” it will be a good thing!
The things that cause inflation today are the same as they have been over the last several millennia. Political expediency creating more claims on wealth than exists via endless debasement of the medium of exchange.
Humans never change – we just can’t help ourselves. Every single fiat currency in the history of the world has eventually gone to zero.. the system gaurantees this to be its eventual fate.
“These wider trends (and others) have helped keep lid on inflation for decades. They are beyond the authorities’ control.”
I don’t agree with this. We’ve had high inflation for years, but it’s mainly affected asset prices. Measures like CPI and RPI, based on stuff you buy at the supermarket, don’t capture the full picture. The cause has been falling interest rates, lose monetary policy and more recently quantitative easing. Currently, real interest rates are negative, which is inflationary, and there’s no sign that central banks will let them get anywhere near positive in real terms. Expect runaway house prices to continue.
As for wages, RPI-linked pay rises will push them up nominally but they are falling in real terms.
The main thing driving inflation is monetary policy.
This seemed the most relevant thread to post a scorecard from July 2023 on how the main economic schools of thought each fared diagnosing high inflation:
https://www.noahpinion.blog/p/grading-the-economic-schools-of-thought
Maybe a bit hard on MMT in my opinion, but I’m probably biased towards them.
@ZXSpectrum48k #6, respect is due to you for your having come closest in comments from Feb 2022 in calling future inflation trajectory, although it turned out a fair bit worse in the end.