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 [1] 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:
[2]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 [3]?
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 [4]. 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 [5] 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 [6] 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 [7] 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% [8] 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 [9]. They see a housing boom in the US [10], the UK [11], and elsewhere [12]. They point to meme stock [13] 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 [14] 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 [15] 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 [16] 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 [17] earlier this month for urging wage restraint. But we should understand where he’s coming from.
I’d be all for fat cat [18] 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:
[19]Source: FT [20]
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:
[21]Source: ONS [22]
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 [23] 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 [24] 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.