Inflation has been on the rise recently in the UK and around the world. Is this rise transitory, as central bankers are saying it is, or persistent and therefore cause for concern?
The importance of this question cannot be understated. The high inflation of the ’60s and ’70s did huge damage to economies and financial markets – as did, for a while, the high interest rates in the early ’80s that were needed to stamp it out.
Balanced funds – those investing in bonds and equities in similar proportions – performed far worse in real terms during what is known as ‘The Great Inflation’ than they did during the two financial meltdowns of the 1930s. The reason for this was that although the deflation of the ’30s was bad for equities, it was great for real returns from government bonds. The Great Inflation on the other hand hit both.
Stated aims and feedback loops
The stated aim for central banks, explicitly or otherwise, is to maintain stable prices and achieve full employment. However, these are not mutually exclusive. There may be circumstances in which a level of employment that is deemed below full can cause inflation to rise.
Take the present, for example. Unemployment is still high but labour markets are tight – causing wage pressures to increase – because Covid-19-related enforced saving has led, at the margin, people to feel they do not need to work.
The role of inflation expectations is critical. Once there is a belief that above-target inflation is here to stay – non-transitory – positive feedback loops, known in the trade as multiple expectations- based dynamic feedback loops, can drive it relentlessly higher.
Furthermore, anchored inflation expectations rely on a widespread belief that central banks will do whatever it takes to stop inflation expectations rising too much.
For the US Federal Reserve to say that it will tolerate above- target inflation for an unspecified amount of time but also that the recent high and rising inflation is transitory appears contradictory and risks damaging its most important asset: its credibility.
At the same time, there is good reason to believe that the current high inflation – in the UK it would now be closer to 4% without the VAT cut – will indeed be transitory. The structural forces that are deemed by many economists to have driven down the natural rate of interest – and with it inflation – over the past 40 years such as ageing populations, high wealth inequality and how labour intensity still prevail.
Once the current drivers of high inflation, namely base effects and artificially high savings rates are behind us, these forces may re-engage.
Predicting the unpredictable
I find it hard to decide where I stand on this question. Inflation is one of those things that is far more complex than it appears. Karl Smith, adjunct scholar at the Tax Foundation, noted in a 2013 article that economies trace a “complex path in higher dimensional space and that what we witness is the shadow of that path cast on to our two dimensions of unemployment and inflation”.
In other words, economies and inflation are unpredictable. Another article by Michael Bryan at the Federal Reserve Bank of Atlanta about the causes of The Great Inflation notes that things are different now to how they were back then. “Today,” he notes, “central banks understand that a commitment to price stability is essential for good monetary policy.”
He obviously wrote this before August last year when Fed chairman Jerome Powell announced higher inflation would be tolerated for the time being.
The good news is that even if inflation stays high for the next year or so it will still be deemed transitory – high inflation, by definition, can only be considered entrenched after a prolonged period – so in the meantime, monetary policy will remain loose and thus supportive of equity markets.
The longer term is harder to gauge, and perhaps the best policy is to be ready to use some dry powder if there is a big fall in markets as a result of rising fears over inflation and interest rates.
A paradox at the heart of central banks is that their job is to promote full employment and low inflation, not to get their predictions correct. However, getting their latest prediction
– the one about current high inflation being transitory – wrong would damage credibility and render much harder to achieve the former. This feels like a high stakes game.
Peter Elston is the former chief investment officer of Seneca Investment Managers.