First published in LCP Vista
If I had £1 for every article I’ve seen on inflation … well, I might just have enough for a basket of goods, at today’s prices! And it’s a big week this week for inflation watchers with Fed, BoE & BoJ
So … I did my best to summarise all the arguments in 1000 words:
Will the dog bark?
In Silver Blaze, a short story by Arthur Conan Doyle, our hero Holmes solves a mystery with the help of the observation that the absence of a dog bark held the key to answering the question of who stole the prize horse. Sometimes the absence of a thing is the key point.
Investors might have a familiar feeling about inflation – conspicuous by its absence since the 2008 crisis in the face of massive monetary stimulus, growth in central bank balance sheets, and a decade of strong economic growth.
Towards the end of 2020, huge increases in UK government spending, borrowing and QE were announced including a record peacetime deficit and a total QE stock approaching £900bn. Meanwhile in the US a $1.9trn stimulus has just passed and something like 1 in every 5 dollars in existence was created last year.
These vast increases to money supply and liquidity have to be inflationary, don’t they?
There are two schools of thought when it comes to inflation:
The case for inflation
Those worried about inflation (sometimes called “inflation hawks”) tend to lean on three key lines of argument: classic economic theories on the effect of spending and money supply, the new trend of de-globalisation, and a post-Covid-19 surge in demand/constraints in supply.
Conventional economic thinking would have that inflation is only contained by the promise that deficits will come down, and the Bank of England’s balance sheet will reduce at some point in the future, but that looks an ever more distant and shaky promise in the UK and other advanced economies.
How can the Government realistically afford to repay the Bank? One fairly easy way is for inflation to reduce the real burden of doing it. The other ways to reduce the debt burden all look unpalatable, impossible, or unlikely (default, austerity, or growth).
While inflation hawks jump to the risk of a sudden sharp burst of inflation (or even, hyperinflation), inflation of 4-5% for 20 years could be enough to put a big dent in even quite large borrowing numbers. Even inflation sustained at 4-5% in a world of zero interest rates would be very damaging to investors in real terms. But how likely is a modest but steady period of inflation? It can be a tricky beast… trying to coax it into life when it’s dormant isn’t easy (ask Japan), and trying to keep it under control once it’s out of the cage is a challenge at the other end.
It’s easy to get sceptical about the argument that low economic activity will keep inflation down for long with this spending – there’s plenty of inflation in Venezuela after all and that hasn’t grown much.
The trend of de-globalisation could be an important new force here. One of President Biden’s first actions was to sign an executive order for federal procurers to “Buy American”. By some measures, globalisation peaked around 2008 and has been in retreat for a decade. Could the trend of “reshoring” resurrect wage pressure as a source of inflation?
Finally, the current economic stress does not follow the typical playbook. Government spending and remote working has meant that many households’ disposable income and savings rates have risen. An end to lockdowns could release a surge of spending.
The case against inflation
Inflation doves cite three arguments in their favour: evidence over the last decade, current low employment and breakdown of conventional economic models.
Those worried about inflation are usually cautioned to reflect on the last decade, over which inflation has fallen in the face of low rates and expanding QE. There has been a lot of capital chasing opportunities in a tech-driven world where capital is needed less than ever, which tilts the supply/demand dynamics of money in favour of low inflation.
Bond investors don’t seem too worried about an inflation surge. From the difference in yields available on index-linked and fixed government bonds, we can look at what bond investors are assuming for inflation: it’s about 3%.
As far as hyperinflation is concerned, studies show this is more of a behavioural phenomenon associated with extreme events such as regime change or war.
The final plank of the doves argument rests on challenging some of the orthodox economic beliefs. We certainly live in interesting times and many conventional theories of the world have been challenged – have the drivers of inflation changed for good? We discuss this further below.
Probably the dominant view among economists we speak to is that inflation can’t return until the economy starts recovering. After all, Covid-19 has been one hell of a deflationary shock – with a collapse in aggregate demand outstripping the collapse in supply. There was not much inflation when we were close to full employment in late-2019 and now many millions are unemployed. This balance is not seen as changing radically anytime soon.
Are the tried and tested theories getting worn out?
A counter to conventional thinking has gained popularity recently – Modern Monetary Theory – espoused by Stephanie Kelton in the book The Deficit Myth seeks to challenge the conventional limits placed on government borrowing to finance deficits. This remains a relatively radical theory, but it is always worth challenging conventional beliefs.
Perhaps a lot of the old economic theories have been ripped significantly to breaking point, and new theories are needed. If the UK were acting alone in a bubble printing money to this extent then it’s likely inflation would come, but that ignores the rest of the world, and that has been the big failure of many economic models of recent decades. In the 70s, high inflation was largely due to an oil shock and unions pushing wages.
Things have changed.
The Fed has accepted that the old relationship between employment and inflation is now broken, signalling a new strategy last summer which allows the economy to run hotter before rates would be raised. Oil is another piece of the old economic theory that’s becoming less and less relevant. Even if you don’t buy into Modern Monetary Theory, it is hard to dispute that economists have a poor track record in forecasting the deficit levels at which problems occur. Many of the points of no return warned about have come to pass with no noticeable ill-effects. Why should we accept their premise that debt levels must at some point become a problem?
The classic concern about rampant inflation is if employees get the upper hand in wage negotiations, but this seems like another relic of the late-twentieth-century economic order. Falls in unionisation and the increase in part-time work and self-employed make this unlikely. Full employment could be far from that suggested by official numbers.
While debating the underlying drivers of inflation has more twists and turns than a Conan Doyle masterpiece, it isn’t likely to yield clear answers anytime soon – even perhaps to a mind as sharp as Sherlock Holmes. A more relevant question for investors to turn to is ‘so what?’ – what could investors realistically do in terms of hedges or inflation-proof assets? My colleague Matt Gibson addresses this question.