The issue is particularly acute in the UK, and the choice for the Bank of England (BoE) is stark. Whilst contending with the highest inflation rate for 30 years, the BoE is also balancing a shallow medium-term growth outlook that barely gets above 1% GDP growth in 2 years. Last year, the rate of the UK’s CPI inflation was 0.6% per annum, and it is now 6.2%.
The form of inflation we are currently observing is one where too much money is chasing too few goods. During the pandemic, as well as other recent crises, Central Banks lowered interest rates, printing money to stave off deflation. Meanwhile, governments went on large spending sprees - introducing direct subsidy schemes (“helicopter money”) and support in the form of furlough schemes. People also stayed at home and saved money. Following the end of lockdowns, people in the West sought to spend those savings. Goods suppliers could not keep up with the onslaught of demand, creating choke points and backups. Such difficulties were hindered further by China, a mass goods supplier, still experiencing lockdowns. Even before Russia invaded Ukraine, commodity prices were increasing: In February 2021, oil was around $60 per barrel and by end of February this year it was over $100.
The conundrum is this: If interest rates are increased too far or too fast, the BoE will push the UK into recession. On the other hand, if they are not raised to a sufficient level or quickly enough, inflation may escalate. This has the potential to erode living standards whilst also requiring even stronger rates of action in the future. Central Banks, the BoE included, are hoping that a stitch in time will indeed save nine in the future.
So how do they proceed?
Firstly, commodity prices don’t need to fall for inflation to fall, they just need to stop rising. If oil prices go from $50 to $100 in a year, the rate of inflation is 100%. If they stay at $100 for a second year, the rate of inflation between year 1 and year 2 is 0%. The price level is higher but all the inflation occurred in year 1.
Secondly, in that example, consumers in year 2 can afford fewer goods with the same money. Other things being equal, consumers would spend more money on energy and less on other products. The result is therefore deflationary. As a result, some economists believe that central banks should be slightly more relaxed on acting against inflation when commodity prices are high. This is a view the BoE seems to have sympathy with, given their recent dovish tone and rowing back from a potential 0.5% rate rise. With taxes also set to rise in real terms, there is some tightening already in the system’s disposable incomes, further adding to the deflationary effects.
Natural deflation is a risk
Expecting inflation to come down naturally is not without risk. Commodity prices may not behave as expected, and, worse, expectations of high inflation may become entrenched which could lead to continued upward pressures on wages. This would damage Central Bank credibility which could take decades to be restored. To some extent, markets are already pricing this scenario, with medium-term inflation expectations for CPI at around 3% - the very upper end of the BoE’s target. This demonstrates that markets don’t believe the BoE will be able to reduce inflation to its 2% target.
Whilst the BoE has been taking a more dovish tone, the US Federal Reserve (the Fed) has turned distinctly more hawkish. At the start of the year, markets were pricing interest rate rises of 0.75% over the following 12 months. By the end of March, that had changed to 2.5% of expected increases. This represents a significant acceleration compared to the BoE, despite inflation expectations over the next 2 years averaging 1% more in the UK than the US.
How, therefore, can the Fed justify increasing rates by so much more than the Bank of England? Quite simply, the US economy is in a much better position than the UK’s. Over the last five years, the US economy has, on average, grown by 1% more per year than the UK’s, and this outperformance is widely forecast to continue. The Fed has a much longer runway in which to raise rates and avoid recession, cushioned by that better backdrop.
Where does this leave markets and investors? High levels of volatility are the only thing that can be predicted with relative certainty. It is entirely plausible that the UK increases rates to 2% this year and then cuts them in the next. We might also never reach 2%. Equity markets have been remarkably resilient throughout this uncertainty (not to mention quickly sailing through the various crises we have been subject to) demonstrating how, in the medium-term, equities do not care about geopolitical effects and are perceived to be a better hedge for inflation than fixed income bonds. Whilst the removal of liquidity (as Central Banks pull back quantitative easing programmes) and the end of ultra-low interest rates will have a negative impact, this may be more than offset but economic strength, at least in the US.