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Are we underestimating the inflation tiger?


I GRADUATED in the heady days of 1987, a period of great optimism. Britain was back. After the grim 1970s which I vaguely remember with rose-tinted specs, the 80s was the decade that gave the nation its mojo. Our self-confidence was back and this laid the foundations for the prosperity that future politicians would squander, gradually at first and then in a most cavalier and careless manner. 

The contrast of the success of the 1980s with the 1970s could not have been more stark, and is a good reminder that with the right policy choices things can be turned round quite quickly.

Looking at the economic situation today, until very recently the Office of Budgetary Responsibility (OBR – the Government’s official economic forecaster) was arguing that there was very little inflation risk, then when inflation reached 5 per cent it was of course only temporary, as a result of short -term lockdown related factors: ‘There’s no need to worry.’

Today the narrative has changed a bit. The OBR says the war in Ukraine is largely to blame, but while it will be a bit tough this year, don’t worry chaps, it will soon subside. It forecasts CPI (a somewhat more generous measure than RPI) of 7.4 per cent this year subsiding to 4 per cent next year and back to below the Bank of England’s 2 per cent mandate by 2024. If that comes to pass I shall be astonished and delighted!

We have become used to apparent price stability. CPI had been broadly sub 2 per cent for 20-plus years, albeit I believe the official data is highly misleading as the average hides a very wide variation between Aldi products at one extreme and more rarefied or unique products or assets at the other. 

But if humans, for perfectly rational and emotional reasons have, as psychologists put it, a normalcy bias‘, assuming what has recently gone before will continue, rather than a more holistic risk appraisal, it is perhaps worth recalling exactly what happened to inflation in the 1970s to rectify possible complacency. The chart below shows how extreme the loss of confidence in money was then. 

So severe was the inflationary impact that a pound in 1970 had lost almost 75 per cent of its value within a mere decade. To keep pace with inflation, a £10,000 salary in 1970 would need to have grown to £36,400 by 1980 just to stand still. This was a disaster for the economy, but the great winners were those with assets (house prices rocketed) and debt. The biggest winner of all was the Government who saw the national debt inflated away. It was rather less good news for those on fixed incomes, savers and the prudent. 

Inflation is thus not good. It rewards arbitrarily the profligate and destabilises society. 

To be clear, I am not arguing that the 2020s are like the 1970s. The circumstances are very different, most notably that while the 1970s oil shock (like the Russian sanctions effect) was universal, the UK had a particularly bad 1970s experience relative to northern European countries and the US simply due to weak Government, constant political interference in industry and wages, trade union power and poor productivity.

While the circumstances are different today in some senses, they are, however, more severe as the issues are largely global, not national. Virtually all Western economies have struggled to normalise post the Global Financial Crisis (GFC) of 2008, which was compounded by near-universal lockdown insanity causing one monumental shock to the global economy. 

Effectively, central banks have debased their currency through unprecedented monetary activism by suppressing the cost of borrowing and effectively printing money via quantitative easing to fund record public sector deficits. This has been the case, to varying degrees, for well over a decade now.

Expansionary Government and central bank policy was initially masked by the growth of China exporting its cheap labour costs, a massive productivity boom largely fuelled by digital technology and mass global migration driving down local labour costs. 

This capped inflation in many things but, as I have discussed, not rarefied product or real assets. 

Critically it also appears to have given Governments a false belief in the omnipotence of highly expansionary monetary policy. Indeed some economists even argue ‘Why not just print what is required as tokens of credit to meet so-called social justice targets?’ Indeed, how marvellous! Shake the magic money tree and simply enjoy our own Eden without having to bother to work! Such ideas are of course absurd and lead to monetary destruction over time. 

Unfortunately, in my judgement, the degree of financial dislocation over the last decade has been so extreme, and exacerbated by the tragedy of lockdown, that even prior to the Ukrainian crisis we faced a significant inflationary shock. 

Prior to the Ukrainian crisis that hit might have been substantial but just about manageable. Now we are entering uncharted territory where the sanctioning of Russia will likely result in severe domestic consequences. 

Energy pricing is the basis of the price of many things, not just heat and light. The energy market had already been corrupted by political interference. Witness the ‘green levy’ that accounts for around a quarter of the average electricity bill and the increasing un-costed attempt to ‘cancel’ carbon. 

One might take the view that sanctioning Russia was morally the right thing to do but if one takes that view it is critical that there is an intelligent debate on the consequences not just to the UK but also the West generally. 

As is well documented, Russia is the third largest oil producer after the US and Saudi, and it accounts for almost 13 per cent of global production. It is thus no surprise that its dislocation has sent oil prices around 50-60 per cent higher than 12 months ago. This is at a time when another potentially large producer, Venezuela, is hobbled by its Chavista regime. The impact Russia has on EU gas supply is even more profound as is its connectivity in a number of other base metal and agricultural products.

As a point of reference, the current UK inflation rate of 7 per cent is before the 40 per cent rise in domestic heating prices in April. Worse, the current energy spot is around 50 per cent above that price rise. Come the energy new cap in six months’ time further substantial price rises, just before winter, are highly likely. Average family fuel bills have already jumped from £1,200 to £1,900 per annum. The current spot price implies a figure closer to £2,800. Such an outcome could only lead to significant economic and political distress. 

Domestic heating is, however, only half the story. The impact on food prices in particular but also most manufactured product has not yet been felt. In my view, producers will seek to hold price increases down via product adjustment but this can be done for only so long. Expect significant prices rises across a very wide range of goods building over the next 12-18 months. Large wage demands are inevitable. 

The traditional way to calm inflationary pressures is to raise interest rates and indeed the Bank of England has belatedly done just that. However, a base rate of 0.75 per cent when inflation is 7 per cent says it all. 

The critical error was the failure of all major western central banks to normalise policy over the period post the global financial crisis. They had a decade to do so. Instead they took the politically easy option and ran economies on monetary sugar. That might be fine when China deflates the price of things and there are no shocks but it was a delusional solution completely unable to cope with the unexpected. 

Now the unexpected has hit, most severely in terms of the ill-advised global lockdown but compounded by the impact of the war in Ukraine on energy and food markets. So novel are the set of circumstances we face that modelling prediction is problematic as many unknowns persist, not least the duration, outcome and political response of war. That caveat accepted, I would make the following observations. 

First, central banks seem remarkably complacent. In a way they have no option. They can hardly shout ‘panic.’ But the truth is they didn’t prepare for a rainy day, believing they have divine power to micromanage and control the storm clouds. They are now faced with a brutal choice: either accept inflation or engender a monetary tightening which will result in recession.  I fully expect they will remain well behind the inflationary curve, tightening only very modestly and continuing to argue that inflation is only temporary. This is potentially very dangerous.

Second, they will blame the war in Ukraine for their ills. Sure, that has exacerbated the problem, but the problem is largely of their own making, funding excess and wasteful public spending via quantitative easing, keeping interest rates ultra-low and indulging in highly inflationary woke economics like net zero. It is critical that the true understanding of the crisis is understood or else we risk compounding error on error.

Third, the data is likely to be volatile but the Bank of England’s assumptions that inflation will be back below trend by 2024 looks frankly eccentric. Sadly, while I am professionally forecasting 10 per cent, 8 per cent and 5-7 per cent over the next three years (i.e. a 25 per cent debasement in the value of money over three years) with recession likely by early/ mid 2023, the risks to my forecasts are appreciably on the downside. 

Fourth, if inflation proves to be as embedded as I fear, what credibility will central banks really have? Who will trust sterling, euros and US dollars if inflation is 12-13 per cent and interest rates are 0.75 per cent? What impact will that have on asset prices, debt holders, real estate and the like? 

Fifth, this will unfortunately create a highly toxic political debate with demands for yet more Government interference and taxation. Such an outcome will only make matters far worse and must be challenged.

If we are to get out of this self-dug hole, the Chancellor needs to address urgently the root cause of the problem, monetary extremism, a state that is way too inefficient and large to be effective, and a regulatory structure that strangles and simply does not trust the individual or corporation but instead bizarrely gives credence to the Civil Service view.

So, what to do both to stimulate the economy and tame inflation?

First, we need a clearly articulated plan to reduce the size of the State from a current 53 per cent of GDP initially, to around 40 per cent within 5-6 years and subsequently to the low 30s of the late 1980s. That would be a great start. Public spending, which increased by a staggering 32 per cent in 2020, must be rigorously controlled with the state concentrating on core tasks, exiting numerous roles which it has filled in the last couple of decades. A state well over 50 per cent of GDP is not consistent with a free society.

Second, cuts in spending should be accompanied by significant tax cuts. Such cuts would help stimulate growth and thus, while initially resulting in increased public borrowing, would on the modelling I have examined be self-funding on a five-year basis via higher growth. A vibrant private sector raises growth and increases the tax take. 

Third, this Government has made Britain Global Regulation Central – regulating everything from press freedom via Ofcom to banning the diesel engine. Anything that moves is regulated. Urgently we need to undo this mess. If, for example, you want a green society the way to achieve it is via the private sector and the extraordinary innovation that it brings, not behaving like some commissar banning, poking and bullying. In the short term, scrap net zero and use the gift of oil, gas and fracking in abundance on our shores. Let the market dictate the price, not the Ministry.

Fourth, if we do these things monetary policy will gradually normalise as the economy will regain its buoyancy. While weaning the nation off such monetary extremism cannot be done quickly it must be done to provide any sort of equilibrium. Only sane small-state, relatively free market economics provide any chance of that outcome.

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Ewen Stewart
Ewen Stewart
Ewen Stewart is a City economist who runs the consultancy Walbrook Economics. He is director of the think tank Global Britain and his work is widely published in economics and political journals.

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