Dead, but not buried

Originally published in the November 2008 issue

Inflation has been in the spotlight over the past year with the UK headline CPI rate hitting 5.2% in September, the highest level for seventeen years. The question now is whether the recent deterioration will prove to be an aberration, or the start of a period where we are subject to frequent bursts of inflation which prove to be more difficult to control in the future?

We expect UK inflation to decline in 2009 with the headline CPI rate falling below its 2% target during the year. Thereafter, inflation is likely to stay subdued, with a risk that it falls further, as there will be a considerable lag before economic slack is reduced and labour and product markets become tight again.

In our view, inflation fears will fade and given our outlook for activity it is quite possible that they are replaced by deflation concerns in coming months as inflation falls sharply. Despite this, we do not believe that the inflation scare of 2008 will be the last. Looking beyond the next two years, inflation is likely to become more difficult to control largely as a result of two structural developments: the changing balance of global growth and the threat from fiscal expansion and higher government debt.

The changing balance of global growth
The world seemed to reach a tipping point in 2008 where the impact of the emerging economies on prices turned from being deflationary to inflationary. It is widely agreed that the influx of new workers into the world economy over the past twenty years has provided an enormous boost to trade and has contributed to downward pressure on prices and wages in the OECD.

As Alan Greenspan put it “well over a billion workers, many well educated, all low paid (moved) to the world competitive marketplace from economies that had been almost wholly or partly centrally planned and insulated from global competition. This movement of workers into the market place reduced world wages, inflation, inflation expectations and interest rates.”(1)


This process continues, as for example, China and India still wish to integrate the surplus labour in their rural agricultural sectors into the industrial economy. However, the increasing importance of the emerging economies is now being felt in other areas such as commodity markets where, in many cases, they have become the main source of marginal demand.

Although the OECD economies are making efforts to slow their consumption of commodities, driven in large part by environmental concerns, such action is likely to be offset by the growth of demand elsewhere. The problem is exacerbated by the less efficient use of commodities in the emerging world where energy and food are often subsidised in price. This means that unless the supply of commodities begins to rise at a similar rate, which seems unlikely, a revival in the world economy in coming years will run into commodity constraints more rapidly than before. The result will be another surge in commodity prices and inflation, as seen in 2008. Headline inflation rates will rise and central banks will once again worry about second round effects. Even if these fail to materialise and inflation falls back, the result will be a higher average inflation rate. For example, the Bank of England is only required to target future inflation, not a rolling average which would require it to respond to an overshoot by driving inflation below target for a period. Consequently, in a world where we face upward shocks to inflation the average long run inflation rate will be above the target level.

The threat from fiscal expansion and higher government debt
The credit crunch has forced governments around the world to commit capital to the financial system, either through guarantees on deposits and interbank lending or by injecting funds to recapitalise banks. In addition to this, many are planning a fiscal boost for their flagging economies. In the UK, the Chancellor has recently disowned the golden rules on government borrowing and debt in favour of a more flexible approach.(2)

An expansion of fiscal policy during a time of economic weakness is a sensible response to recession. If the combined action of governments and central banks is successful in easing the credit crunch, the authorities should see borrowing fall back as recovery takes hold. It is also likely that loans and investments to the banking sector are repaid, providing a further improvement to the government balance sheet.

The threat to inflation comes from the risk that the authorities are slow to withdraw fiscal support as private sector demand recovers. This could rapidly result in a return to overheating as demand outstrips supply. Not withstanding the political pressure to keep supporting the economy, the long lags on fiscal policy mean that it is difficult to turn the stimulus off at precisely the right moment. The risk is increased in this case as it is harder to gauge global multiplier effects when a number of countries are expanding fiscal policy at the same time.

At this point the strength of the headwind facing activity as a result of the credit crunch means that over stimulating the economy is a distant threat, but it remains a potential danger to the medium term stability of inflation.

Pressure to change the inflation target?
The greater problem may come if governments and the public start to believe that a bit of inflation is a good thing. In an environment where debt levels, both public and private, are uncomfortably high there is an incentive to create a little inflation to ease the burden. In extreme circumstances this would mean the government printing money and distributing it to households. Such action would not be taken in the UK, but do not rule out a more subtle approach such as altering the terms of monetary policy. The framework was created by the government and can be altered by the government.

Most economists today regard current UK monetary policy as a success story: an independent Bank of England setting interest rates so as to bring CPI inflation to 2% over a reasonable time period without creating undue instability in the economy. However, an oft overlooked subsidiary objective is that, subject to delivering price stability, the Bank’s monetary policy should support the Government’s economic objectives for growth and employment. The Chancellor recently referred to this and in arguing that inflation was coming under control, pressed the Bank to give more weight to this aim.

Alternatively the government could simply move the inflation target up, to say 3% or even 4%. The Governor of the Bank would certainly object arguing that there is no long run trade off between growth and inflation, but ultimately his position is also determined by the government. Given that we expect inflation will prove more costly to control in terms of output and jobs in the future, political pressure on the setting of monetary policy is likely to increase.

Implications for investors
In the near term, fears of higher inflation should be taken care of by the credit crunch and it is possible that concerns turn to deflation. The lack of growth will be the bigger worry. Looking further out though the changing balance of activity in the world economy means that upward pressures on commodity prices are likely to re-surface at an earlier stage of the cycle than in the past, causing headline inflation to spike higher.

The environment for controlling inflation will become more difficult (something the Bank Governor has referred to as the end of the NICE decade(3)) such that the cost of reducing inflation in terms of output is greater. Combine this with the increase in government debt and it is not difficult to see the framework for monetary policy in the UK coming under close scrutiny. Investors may relax about the outlook for inflation over the next year or so, but should be aware that thereafter the risks become increasingly skewed to the upside. The recent correspondence between the Governor of the Bank of England and the Chancellor will not be their last exchange on the subject of inflation.

The views and opinions contained herein are those of Keith Wade, Chief Economist, and do not necessarily represent Schroder Investment Management Limited’s house view

1. Alan Greenspan: The Age of Turbulence, 2007
2. See The Mais Lecture on ‘Maintaining stability in a global economy’ given by The Chancellor of the Exchequer, 29 October 2008
3. The Non Inflationary Constantly Expanding economy