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Monday, November 7, 2016

Inflation

The boring stuff is probably much more important for investors

How much (and whether) global investments in ten years’ time will be helped or hindered by a President Trump rather than a President Clinton is largely a matter of speculation. Of more relevance to UK investors are the less engaging subjects of the prospects for UK inflation and interest rates.

These are more relevant because they constitute risks which investors can sensibly weigh, and decide to adjust investment strategy if they don’t like the apparent balance of risks.

Sterling has devalued by over 15% since June’s Brexit referendum and since then the gilt market has pointed to a pick up in average CPI inflation in the next 10 years from 2.5% per year to 3.3% per year (technical factors make it reasonable to expect actual inflation to be a bit lower than this).

This may not sound much of an increase, but 2% inflation erodes the value of money by half over 20 years, while 3% reduces it by 80%.  Subtle and persistent increases in inflation are the enemy of those who rely on private pensions.

Some increase in UK inflation was an inevitable consequence of the devaluation of Sterling.  The government’s preferred measure of CPI inflation has averaged 2% since 2000, the same as the Bank of England’s target, but is expected to increase from close to 1% in 2016 to just under 3% in 2017 and 2018, largely reflecting the impact of Sterling’s devaluation on higher import prices.

The Bank expect inflation then to fall back as the currency effect passes through.  The extent to which this happens will depend on whether faster inflation feeds through to a persistent increase in wage costs.  The gilt market is suggesting a less sanguine picture after 2019.

So what does cause inflation?

Different economists have always given differing accounts of the causes of inflation, how it can best be managed and how much it matters.  During the 1970s, when annual inflation averaged 13% in the UK and over 7% in the US, this was an area of bitter dispute between competing schools of economists.  Milton Friedman had famously said in the 1960s that “inflation is always and everywhere a monetary phenomenon” and monetarism substantially won the policy debate of the 1970s.  The Bank of England and the Federal Reserve (following the earlier examples of Germany and Switzerland) adopted formal policy targets for the growth in the money supply.

A generation later, in a very different environment, agnosticism rules, and central banks have injected massive amounts of liquidity to support economic activity, and have done so with almost no discernible impact (at least, so far) on inflation.

Furthermore, few economists would have expected the UK to achieve such a sustained reduction in unemployment in recent years with little apparent pass-through to higher wage settlements or inflation.  Old seemingly more-or-less reliable relationships are no longer relied upon to explain inflation.

 

UK consumer price inflation

 

UK unemployment rate

 

Janet Yellen, the chair of the Federal Reserve last month reflected this lack of conviction (which should not be confused with a lack of analytical rigour) when she set academics the exam question “what causes inflation?”  Milton Friedman must be turning in his grave.  This question concerns the underlying drivers of the trend of inflation and should be distinguished from the arithmetic accounting for recent price changes such as moves in the oil price or food prices or the exchange rate.

Current academic thinking is that the level of inflation is strongly influenced by its trend and what people expect inflation to be in the future. In turn this is influenced by the stance of monetary policy, whose key role is to anchor peoples’ expectations for future inflation.

In the UK inflation has averaged around 2%, ever since the Bank of England adopted a policy of targeting inflation in the early 1990s.  However, during the financial crisis, the accompanying sharp devaluation of Sterling fed through to a spike in inflation to 5% in 2008, a spike which was then repeated in 2011, partly due to an increase in Value Added Tax, and higher utility costs.

A key role for central banks is to prevent these price shocks feeding through to the trend rate of inflation people expect over time.  In 2008 and 2011 in the UK the inflation rate soon fell back.  The success of the Bank of England in keeping a lid on trend inflation matters enormously to the standard of living of those reliant on private pensions.  The Bank’s difficulty in ensuring this will depend on circumstances which are largely outside its control.

Whether central banks succeed in this fundamental role may depend on whether governments are thought credible in how they manage their finances.  Donald Trump’s loose talk about repaying the Federal government debt, or incredible expenditure and tax plans (whether in the US or the UK) could easily and adversely influence whether business and employees expect it to be easier in future to pass on costs and so the typical level of inflation they expect.

Investors must be continuously on their guard for these threats to the value of their wealth.

Peter Stanyer, independent economic consultant to The Financial Planning Corporation LLP
4 November 2016

Peter is the author of The Economist Guide to Investment Strategy, 3rd edition, Profile Books, 2014.  The views expressed are his own personal views, and do not constitute advice to buy, sell or hold any investment.

This update has made use of the Grumpy Economist blog of John Cochrane, of the Hoover Institution at Stanford University.


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