A very short history of inflation
It’s helpful to think of inflation in terms of the old adage, too much money chasing too few goods. But don’t let the simplicity of that statement fool you: the factors that influence the flow of money and the amount of goods (and services) produced are vast, and we have limited our discussion to three broad topics.
In the first section, we delve into demography and ask how patterns of ageing and saving might influence inflation. In the second section, we explore globalisation — its net effect may not be what you think. In the third, we ask how patterns of employment impact prices and whether changing patterns of work — more self- and part-time employment, for example — might alter the relationship. We then offer a range of inflation scenarios and give you our thoughts on their likelihood. We follow this up by looking at what investment strategies we think will do best in different inflation environments.
We also want to set out what we’ve omitted. We haven’t picked apart the inflationary or deflationary forces that Brexit might impart. In the worst-case scenario, Brexit would represent a shock to the productive capacity of the country. In advanced economies, such shocks tend to have a transitory effect on inflation and are unlikely to influence the long-term trend. Brexit would be more likely to have a lasting impact on interest rates and the exchange rate. Please refer to our report If you leave me now for a comprehensive overview of how we think leaving the European Union may impact the UK economy. Second, we have not discussed the effect of quantitative easing. We’re discussing what drives inflation over the long run. The tightening or loosening of monetary policy in the name of meeting central banks’ inflation targets — by ordinary or extraordinary means — is only likely to impact inflation temporarily.
But first, how did prices get to where they are today?
A personal experience
Inflation in the UK has averaged 2.1% a year over the past 25 years, but during the 25 years before that it averaged 8.4%, breaching 25% in the 1970s. We’re all susceptible to assuming our past experiences are the rule rather than the exception. Older readers may be tempted to think the recent quiescence is unusual. If that’s you, you are in good company. A fascinating (if rather unnerving) paper by three economists at Berkeley has revealed how personal experiences of inflation have strongly influenced the voting tendencies of Federal Reserve (Fed) policymakers over the past 60 years.
In other words, rather than setting interest rates based solely on prevailing economic fundamentals, those highly intelligent men and women tasked with steering the US economy have been swayed strongly by the rate of inflation they have experienced during their lifetimes (Malmendier et al, 2017). In figure 1 we plot the rate of inflation over the past 250 years, which shows that low inflation is not unusual. High rates of inflation in the 1970s and 1980s were rather unique: outside periods of war, inflation has rarely strayed too far away from low single digits. In the 19th century, it averaged 0%.
What drove prices higher in the 1970s and 1980s in the UK was a combination of the unfortunate and the unadvised. The deregulation of mortgage lending and the mass adoption of credit cards fuelled an almighty consumer boom, while the government slashed taxes and made a dash for growth as policymakers assumed the economy had more spare capacity than existed. Wages rose and rose, in no small part due to monopolistic labour unions who called strikes whenever pay caps were mooted, crippling productivity. The 1973 oil crisis doubled the price of petrol. When it all came crashing down, the situation was made far worse by appalling monetary policy decisions that left firms’ and households’ expectations of what prices would be next year — or the year after that — dangerously unanchored.
This perfect storm is unlikely to be repeated. Lessons have been learned the hard way. Since then inflation — and wage inflation — has been characterised by a slow-moving, stable trend (Yellen, 2015). In this paper, we’re interested in what might influence that slow-moving trend over the next 20 years or so. (Few of our non-endowment clients have an investment horizon longer than that).
Figure 1: Low inflation is not unusual
Consumer price inflation (shown here as the five-year moving average rate) has been low for most of the past 300 years and rarely strayed beyond low single digits.
Source: Bank of England and Rathbones.
Inflation is a general rise in prices, not just a few items becoming more expensive here and there. Disinflation tends to mean a slowing rate of price rises, as distinct from deflation, which means outright falling prices. But there is plenty of confusion here and we try to avoid using disinflation.
Inflation is usually defined as the average rise in prices paid by the average consumer. It is calculated by how much money was spent on thousands of different goods and services in the previous year. In the UK, the Office for National Statistics (ONS) captures a data series called the consumer price index (CPI), and the annual rate of change of the CPI is the most commonly used measure of inflation.
What does it mean for me?
You might ask how applicable the rate of inflation experienced by the average consumer is to you. In figures 2 and 3 we’ve calculated rates of inflation based on the expenditures of different age groups and income brackets. There is surprising consistency between them. Over the past 15 years, the CPI for the highest-earning households has averaged 2.1%, the same as the headline index. During this time, prices have risen the most for the lowest earners because they spend more on energy and utility bills (27% on average).
This feature has also made their rate of inflation the least predictable from year to year. Similarly, the difference between the average rate of inflation experienced by different age groups over the past 15 years has been negligible (less than 0.1%), apart from the under 30s, who have faced an extra 0.3% of inflation a year, again due to the higher weighting to utilities.
What about housing costs?
Consumer price indices do not tend to include the costs of purchasing a home. This is a matter of contention if the index is used to measure the cost of living. However, as a measure of inflation — a general rise in prices — it is no bad thing. Housing markets are often highly localised and influenced by factors not applicable to other prices (such as tax rates offered to foreign investors). Meanwhile, mortgage costs depend on personal circumstances in a way that most other prices do not.
The link between mortgage costs and monetary policy is also very different. Central bankers raise interest rates to stop prices rising too quickly. But mortgage costs are directly tied to central bank interest rates, so in the short term higher interest rates would exacerbate, not curb, inflation. In short, if you want to understand what drives prices in general, it’s best to leave houses out of the equation.
Figure 2: Inflation by wealth Figure 3: Inflation by age
UK CPI for personal income declies UK CPI for age cohorts
Source: ONS and Rathbones