“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” — Ronald Reagan

The fact that I’m using a quote by Ronald Reagan to begin this post gives you some context on how long it has been since inflation was an issue. However, an issue it is.

Now that inflation and the “cost of living crisis” has hit the front pages over the last few weeks – even the Daily Express and The Mirror are talking about it – I wanted to take a bit of time to review what is going on, what are the primary causes and what can we expect going forwards. Will we become the next Zimbabwe?

To go back to basics, inflation is the price of goods and services going up. Normally a small amount of inflation is seen as a good thing and a sign of growth within the economy. The Bank of England has an inflation target of 2% and says on its website: “Low and stable inflation is good for the UK’s economy and it is our main monetary policy aim.”

Fine, but interestingly it also included this table on the website. Can you see the dislocation here? Something is not quite working…

U.K CPI hit 7% this month which is the highest rate of inflation since 1991. And for a bonus 10 points. Guess what the Bank of England rate was then? In September 1991 the Bank of England rate was 10.38%. Versus 0.75% today. This gives you an indication on how the views on monetary policy (the setting of interest rates by central banks) have changed in those 30 years.

So what has caused the big recent spike in inflation?

As much as President Biden would love to call this “Putin’s price hike” and Labour want to call this the “Tory cost of living crisis” the origins are much bigger. How big? How does $24 Trillion bigger sound? Is that big enough?

This chart below is now a little old but the total numbers haven’t really come down yet. The chart below is effectively money printing. To describe this in a very simplified manner the central banks print money and use that to buy government bonds and other assets that it then puts on its balance sheet. The theory is it swaps cash for bonds and subsequently releases the cash into the financial system to be loaned out, paid out as benefits etc, ending up in the consumer or business’s pockets.

Since Alan Greenspan started this economic experiment in 1999 global central banks have convinced themselves that more is better when it comes fixing global economic problems with more cash. And each new problem that has arisen, they have arrived faster and with more stimulus than the previous time. Why? The same reason Roman Abramovich kept changing Chelsea managers. Because it’s worked every time. Until it doesn’t.

Let’s look back at some examples over the past 20 years. In 2008 the global financial system nearly came to a grinding halt and was only saved by the liquidity injection we can see above. Between 2010 and 2015 a number of European countries defaulted (or almost defaulted) on their debt and were only saved because the European Central Bank “did whatever it takes” to save them. Then the Covid crash of March 2020 saw the coordinated global shutdown of the world’s economies – again only saved by an enormous injection of cash into the system.

Time and time again we have hit major financial problems and time and time again printing more money has saved the system with very little consequence – until now.

The consequences of printing more money go back hundreds, almost thousands of years. From Roman emperors shaving the sides off their silver coins to Henry VIII debasing the amount of gold and silver for cheaper metals to the German government of the Weimer Republic printing almost unlimited banknotes, Governments and Kings have found the allure of “free money” too easy resist – and each time has not exactly ended well.

Then why did we not have rampant inflation from 2000?

It’s a great question and I will present my thoughts. Please remember these are just my thoughts and I’m sure plenty of better-educated people than me will disagree. And if you do, please reply as I’m always interested in your thoughts.

The first reason we didn’t see inflation was structural to the global economy. There have been two massive deflationary forces pushing prices lower in the global economy since around 2000. Expanding global supply chains saw China and other low-cost countries becoming global suppliers with cheaper factories and workforce offered many businesses the chance to outsource and lower their overall costs. The other massive deflationary force was technology and the world connecting to the internet and all the cost efficiencies that that created. I would argue this still exists somewhat today, but the expanding global supply chain perhaps is reversing. More on that later.

The second reason was more specific to the post-2008 period after the global financial crisis. In 2009 almost every bank globally need to repair it’s balance sheet and did so through hoarding capital. Capital Adequacy Ratios – as in how much cash they needed to hold vs their total loans outstanding – went from in some cases 4% to 14%. This was both a regulatory and economic necessity after the disaster of 2008 and meant that an enormous amount of liquidity – or money printing – produced by central banks ended up getting stuck on bank’s balance sheets and not passed through to the real economy as intended.

So what changed?

It really was the reaction to the March 2020 global market sell-off and lockdowns that changed this. Firstly, the stimulus provided was absolutely enormous, dwarfing virtually all previous responses. Secondly, the stimulus was both monetary AND fiscal. Examples from the fiscal side were the U.K.’s furlough scheme which paid staff to stay home and cost the government £70 Billion and the U.S sent every citizen a cheque for $1,200 in April 2020, then $600 in December, then another $1,400 in March 2021. For context, remember in 2009 we had government austerity as the government CUT spending for the next 5 years after that. The fiscal reaction could not have been more different from then.

In the U.K. we had the combination of furlough payments going directly to the households, plus banks being forced to give out risk-free loans (bounceback loans) of an estimated £80 Billion. A billion here, a billion there, pretty soon we’re starting to talk about real money.

2020 was the only recession in history where household savings went up – see below.

The most interesting part about this chart above in regards to our discussion today is that the savings ratio is back to a normal figure of between 5% and 10%. So where did those surplus savings go? It’s a very good question but only really has two answers – invested or spent.

We certainly saw an increase in investment into markets by retail investors – think back to the Gamestop saga, but I would argue this was relatively small and short-lived. More significantly we have seen consumer expenditure not just come back to previous levels but move higher. The Bank of England now collects CHAPS data from all bank transfer payments. In March 2022, average daily volume of these payments was £385 billion, an increase of 13.3% from March 2021. You can see this YoY trend continuing to rise in the chart below.

This spending increase has been a big factor in the rise in inflation. But are we spending more because we want to or are we spending more because the cost of stuff is going up? The answer in my view is both.

Power bills, fuel prices, global supply chain issues, Russia/UK war etc have all been factors that have pushed up prices from the supply side. But we’ve been paying these prices and as inflation has now hit the front pages, inflationary expectations by consumers have also jumped as shown by the chart below.

It is this sort of data that gets Central Banks nervous. Inflation is very much psychological and you can see according to this table UK inflationary expectations are above 6% for the next 12 months. On the whole the general public expects and accept prices are going up. So we pay them. As businesses recognise the consumer accepts paying more, it means they are able to pass on these price rises from their input costs and the cycle continues. Prices go up, then people pay them. This is what I mean by making Central Bankers nervous as history has shown this cycle can be very hard to break.

So what happens now?

This is where it becomes a little more interesting and nuanced. Clearly a sudden peace in Ukraine would settle a lot of nerves in terms of global commodity prices and supply chain disruptions, but that certainly is not the end of the story.

There is a fascinating statistical quirk that will come in to play over the next few months that I want to highlight. Remember the CPI figure quoted is an annual Year on Year (YoY) figure that represents the move in prices over a 1 year period. The chart below shows this as an Index which makes interesting reading.

What I want to highlight is where the index starts rising in April 2021. This means that any (YoY) figure from now onwards – which will be April 2022 – is going to have to deal with a higher base number. As this base number for the YoY continues to rise, prices will have to rise at a faster level than this for the CPI number to continue rising. The result? We actually will have DOWNWARD pressure on the headline inflation figure, potentially without the actual level of prices falling.

If we do get lower CPI figures over the next few months, then the interesting point to note will be how the Government, Central Banks, and markets spin this. My guess is there will be significant fanfare on this headline and point out that their actions are causing inflation to fall. Why? To try to reduce the inflation expectations we discussed earlier. To try to break the inflationary cycle. Politicians telling lies or misrepresenting statistics for their view of the greater good? No, that’s never happened before….

This doesn’t mean prices come down and I am a believer in the fact that inflation and higher prices will be with us for many years to come. The structural deflationary forces I mentioned earlier whilst not reversing, have been tempered significantly in the past few years. Covid and the Russia/UK war have taught us that self-sufficiency in most industries, especially energy and food, is worth paying a higher price for. I would suggest most people tend to agree with that now, hence there will be an acceptance of these higher prices – those expectations again.

So economically, this probably means higher interest rates than we’ve had over the past 20 years – potentially banks may actually pay you a return for holding savings. It also means bonds will find it a particularly hard environment, as I’ve discussed many times, and the high-growth equity stocks may also find life a little tougher. Real assets that produce income tend to do best in these environments, so its holding shares in quality companies and property with scarcity value – more houses than flats.

Thank you for bearing with me on this longer note than normal. I hope it has given you some insight into how inflation works and what are the potential implications.

As ever if you have questions or comments, please feel free to come back to me.

Adam Walkom

Permanent Wealth Partners

Phone 020 3928 0950

Email adam@permanentwealth.co.uk

LinkedIn www.linkedin.com/in/adamgwalkom