Inflation - is it here to stay?

 

For those who remember the 1970s, the thought of inflation may well fill them with fear. Should we be worried now?

A common definition of inflation is “too much money chasing too few goods”. If lots of people want to buy a house, then it may be sold by auction allowing for the price to “inflate” significantly above what had been expected previously. 

The financial crash of 2009 led to fear that the world’s financial plumbing would seize up completely, resulting in such a collapse in demand that deflation would follow. Deflation is where prices fall from one year to the next. This leads to consumers delaying purchases: in the expectation of getting a better deal later. An absence of demand makes it very hard for an economy to grow and develop. An example of this is Japan where the economy has been stagnant for three decades.

The central banks of the developed world have therefore spent the past twelve years desperately trying to avoid following Japan in the deflation trap. They have done this through Quantitative Easing (QE) – often referred to as “money printing”.

When this novel solution was first proposed, many economists warned that it would produce an inflation nightmare. For a decade they were proved wrong. Where they right after all?

 

In my opinion the answer is not clear cut, but largely they were not.

The QE policy pursued for a decade failed to move the inflation dial anywhere apart from with regards to assets (such as property and the stock market). This is not the inflation that really concerns policymakers and businesses. 

What changed this was the advent of Covid 19. The monetary response to the quarantining of the world’s population was a massive increase in QE, to pay for furloughing workers and so on.

This led to a demand explosion at the same time as the world’s supply chains had largely seized up.

This is why inflation has come from: too much money chasing too few goods.

So arguably it was Covid, not QE per se, that has caused inflation to return for the first time in decades.

 

When inflation first began to appear, a year ago, most commentators agreed that it would be “transitory”, a sudden but passing phenomenon. Prices would increase briefly but not continuously. This has proven to be wishful thinking. The inflation rate has continued to climb through 2022.

The supply chain issues, the global labour shortage and now Russia’s invasion of Ukraine have added more fuel to the inflation fire. 

So is inflation now here to stay?

 The fear now is that huge increase in the cost basic goods such as energy and food will cause a spiral of wage demands. This has led to some analysts to claim that we are returning to a similar situation as we faced in the 1970s when inflation averaged close to 7% and at one point hit 12%.

 

Why did inflation take off in the 1970s?

 There was a combination of factors. One major reason was that the system of exchange rates changed completely after decades of being linked to the price of gold. 

Also OPEC dramatically increased the price of oil.

This led to wage demands which were often accepted, which fed demand and kept inflation spiralling.

This led to a lost decade for investors. While the stock market appeared to perform quite well (as did many housing markets) inflation was eroding the value of this rising wealth, largely negating any increase.

 

So are we back in a similar situation?

There are some key differences.

1. The world economy is less dependent on oil and though the price is increasing it is not (yet) doing so nearly as dramatically. In 1973 OPEC caused the price to rise by 300% from $3 per barrel to twelve. In comparison the price has risen by 66% in the past twelve months. 

 2.  No shock to the foreign exchange markets. There has been nothing like the seismic change to the financial world that President Nixon’s decision to leave the Bretton Woods gold standard caused.

 3.  Labour unions are far weaker. One reason that the wage spiral took hold in the 1970s was the immense power of Trade Unions. Since the 1980s, most Western countries have seen union membership fall dramatically, and with it their negotiating clout.

 

Are investors about to experience another lost decade?

Right now I would argue that that is unlikely.

With food and fuel prices increasing dramatically, along with the high cost of shipping and raw materials, it is easy to conclude that the future is indeed bleak. However things could turn around rather quickly.

I’m not saying that this will all happen, but it could:

 

1.     Rapidly rising interest rates are driving economies into a brick wall. They are predicted by many to start falling again next year. If the brick wall leads to a significant recession then the falls could be dramatic. Rising rates smashed stock valuations, falling rates should give them a boost.

 

2.     China will eventually drop its futile ”Zero Covid” strategy. The opening of the world’s workshop will have a dramatic impact on supply and therefore supply-side inflation. This would further reduce the need for higher interest rates and also allow firms to serve customers at affordable prices.

 

3.     The EU is currently providing Russia with around €1 Billion per day, via purchases of oil and gas. This is estimated to be the exact cost of the war for Russia. If the leaders of Germany and Italy finally accept that funding terrorism is worse than a short sharp hit to their economies, then the war could be over very quickly. This would have a significant impact on food price inflation.

Investors tend to think that the current state of affairs will persist indefinitely then are shocked when it doesn’t. Good times will last forever. Bad times will last indefinitely. This is of course wrong.

Bleak as things are just now, the situation could turn around very quickly.

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Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.