INFLATION TODAY AND TOMORROW � THE COST OF LIVING CRISIS

The 1970s

To be fair to them, no one knew at the time that Russia would invade Ukraine causing chaos in global energy markets. We will never know what inflation would have been today had the invasion never taken place. However, it’s likely this aggression simply added fuel to a fire that was already well alight.

It is now impossible to tune into the news without hearing about inflation and the cost of living crisis. Strikes by public sector staff are prevalent. This is a direct result of

The last period of serious inflation in the rich world was during the 1970s, triggered by two oil shocks, one in 1973 and the other in 1979. The first happened when the forerunner of OPEC imposed an oil embargo on nations, including the US and UK, that had supported Israel in the Yom Kippur war. The price of oil quadrupled from $3 to $12 per barrel (compared to $100 today). Western economies were more manufacturing-based then, so the higher oil price affected economic activity more directly. As these events took place nearly 50 years ago, to remember them you need to be over 60 years old, which many current commentators and decision-makers are not. It seemed obvious in the 1970s that you should buy whatever you needed as soon as possible before its price went up. By the early 1980s inflation and interest rates subsided to a level we would recognise today, and have stayed at low levels apart from a brief aberration in the late 1980s. The recession of the early 1990s killed inflation, seemingly once and for all.

The perceived end of inflation

The main reasons why experts believed that inflation wouldn’t return, as recently as last year, were globalisation along with ‘the three

Gradually the quality of China’s manufactured products improved and the West duly migrated the bulk of its manufacturing to China. In this way China exported deflation – everything you could buy from the Chinese would cost vastly less than you were paying before.

30 years on and Chinese workers have seen a tenfold increase in wages combined with shorter hours. The move from the countryside to the cities has slowed. Meanwhile China’s rulers have become less business-friendly and relations between China and the West have turned frostier. The cost of transporting goods is also rising. The great inflation-busting era of globalisation appears to have come and gone.

Debt

Some have argued that the world has become so indebted that most spare money is consumed in interest payments, leaving little to generate the kind of robust growth which could lead to inflation. The world is indeed more indebted today than ever – at the end of 2021 global debt had risen to a new record of $300 trillion or $37,500 for every person alive.

However, borrowers pay interest to their lenders and the money is therefore

This won’t always be the case of course. If the lender is a bank, as it often is, it will use its income to pay employees and shareholders, who will probably spend it. For the UK government, with its roughly £2trillion of debt, 10% annual inflation knocks a massive £200billion hole in the real value of government debt, an amount equivalent to putting income tax up by 30p in the pound. However, the quarter of UK government debt that’s linked to inflation will still rise in value as inflation goes up, and cost more money to service, partly offsetting the inflation windfall.

Inflation increases the government’s income. As salaries rise, income tax and National Insurance payments rise, all windfall income for the Government unless unemployment rises high enough to offset it. Similarly as prices rise VAT on goods rises, unless spending on goods falls by a greater extent.

Demographics

The generally agreed rule is that older people save and invest, which is deflationary, while younger people borrow and spend, which is inflationary, so the effect of the rising average age of populations tends to be deflationary overall.

However, driven by the pandemic, it’s possible that the long, seemingly inexorable rise in life expectancy may have peaked, at least for the time being. This might be a factor reducing the deflationary effect of an aging population.

Data

Technology increases productivity and that reduces inflation. Computers do much that used to be done by people but computers do it much faster and more accurately. As they grow more powerful, they also get cheaper. The smart phone you could buy today may not cost less money than the one you could have bought a year ago, but it will contain features that weren’t available then. If today’s phone had been available a year ago, it would have cost more than today, so on a like-for like basis the price has dropped, as you are buying a more sophisticated piece of equipment for the same money. This is a small element in the inflation calculation, but difficult to capture in the numbers, meaning that headline inflation always tends to be a little overstated.

Where we are now

During the summer, forecasters were falling over each other to predict ever higher inflation numbers. Goldman Sachs predicted a hefty 22% on August 31st.

Today’s inflation is primarily caused by externalities – global events pushing up the prices of energy and food, and in the UK by the weakness of Sterling, which makes all imported goods more expensive. This type of inflation acts as a tax on the consumers of those products. Central banks are raising interest rates – another tax on consumers –in a bid to curb inflation. This appears to be an attempt to offset the effects of a series of factors which have put pressure on incomes, by putting further pressure on incomes. We are already seeing the start of a period of economic contraction – a recession – at least in the UK. Everyone is concerned at what lies ahead, and spending patterns are being adjusted accordingly. House prices, in a strongly rising trend since the pandemic, are cooling and the number of transactions are falling. All of this is before the effect of higher interest rates has been fully felt in the real economy.

The above is an abridged version of fourth and final article in a series written by our founder, Tony Yarrow. The full article, along with the preceding three can be found on our website if of interest.

Joe Cooper FPFS Chartered Financial Planner

November 2022