The Wolf of inflation prowls menacingly beyond the city gates

Inflation is a beast which can sleep for decades and then revive – and then kill or maim the weak and unprepared. Is that the howl of the beast from afar? In which case, why are our leaders so languidly relaxed? We are living in a fools’ paradise, says Victor Hill.

What keeps Rishi awake at night?

Mr Sunak maintains a calm and temperate demeanour, but in last week’s budget (which I discussed last Friday), and in recent statements, there were indications that he is a worried man. What worries him is inflation and the havoc that it could unleash. People aged under 40 in this country will not have experienced what it is like to live through a period of rampant inflation; but those of us who can remember the 1970s know that it is a destructive force which has economic and political consequences.

Since the financial crisis of 2008-09 interest rates have been at near-zero levels – something which is historically unprecedented – since inflation has been marginal and the economic orthodoxy was to sustain the economy, given inadequate demand, with cheap money. Long-term factors came into play as well, such as an ageing global population, a glut of savings and a decline in the rate at which productivity was increasing.

Rock bottom rates mean that governments can borrow as much money as they think they need at next-to-nothing. So, the £400 billion plus that the coronavirus pandemic has cost the UK Exchequer (£37 billion on test-and-trace alone, we learnt this week) has been easily financed in the gilt markets – with the central bank, the Bank of England, helpfully buying up about half of the gilts issued over the past year. It now carries about £875 billion of QE bonds on its balance sheet. The magic money tree exists – and is thriving in the garden of Number Eleven Downing Street.

Currently, the government pays on average about 0.8 percent per annum on new gilt issues which carry maturities of up to 30 years (by which time the current crop of politicos will be ancient history). But if rates were to crank up by just one percent the annual interest cost of the outstanding stock of debt (nearly £2.3 trillion) would increase by £26 billion, according to the OBR. That would be enough to necessitate budget cuts somewhere – and we would be back to austerity. The austerity strategy followed by the Coalition government (2010-15), when funding for the police and for local government was slashed, is now regarded by many Tories, not least Mr Johnson, as a grave error which cost us dear.

Separately, the Institute for Fiscal Studies (IFS) adjudged the Chancellor’s spending proposals as “implausibly low” – not least because nothing has been budgeted for a re-vaccination programme. In other words, the deficit projections offered last week are unrealistic, and taxes will have to rise further to bridge the gap.

Olivier Blanchard, former IMF Chief Economist, says that so long as a nation’s growth outcome is above its average borrowing rate, its debt burden will stabilise. But Jacques de Larosière, (a former MD of the IMF, Governor of the Banque de France and head of the EBRD), thinks that central banks should stop holding down long-term bond yields and should start a process of monetary normalisation. (The Fed’s own M2 measure rose by over 25 percent last year). He thinks the EU stimulus package should be guided by efficiency.

Howling in the night

What are the reasons to suppose that inflation could return? Basically, there are three.

Firstly, massive fiscal stimuli are at work, internationally. This week Congress approved President Biden’s £1.9 trillion fiscal give-away designed to crank the US economy back into gear after the ravages of the pandemic. That is more than twice the size of President Obama’s post-crash package. This time, every American adult will receive a cheque for $1,400 to spend as they wish. Larry Summers, Bill Clinton’s Treasury Secretary, has described possible resulting inflation as “an enormous risk”. He thinks the Fed will have to start raising rates as early as next year.

In Europe, the €750 billion Recovery Fund (mostly loans, and stretched over six years) will start disgorging money across the continent soon. And yet UniCredit reckons that the eurozone will not recover to pre-Covid levels of output until mid-2022 – but that German inflation will surge. The ECB has operated with negative interest rates since 2014, since when it has expanded its balance sheet 3.5-fold. That now stands at over 70 percent of eurozone GDP – about double the level of the Fed. Many of the constituent national-level central banks in the eurozone might already be bankrupt. Government bond yields in Europe have also been rising. Spanish government bond yields have spiked, even though the country is technically still in recession.

Then consider the colossal value of global debt which has now reached about 350 percent of world output. Mankind has never been this much indebted – and yet, crazily, $18 trillion of that debt is trading at negative or near-negative yields. 

Second, there are various canaries is in the coal mine that are looking sickly. Gold, which is a classic hedge against inflation, is gaining in value. That suggests that asset allocators are preparing for a bout of inflation. Also, this week oil prices jumped above $70 a barrel for the first time since the pandemic began. That was partly due to a drone attack supposedly by Yemeni Houthi rebels (though Dammam is over 1,000 kilometres from Yemen). Commodities – especially metals – are surging. Mining titans BHP (ASX:BHP) and Glencore (LON:GLEN) have been paying bumper dividends to shareholders in the expectation of a commodities boom.

Moreover, yields in the US Treasury markets are oscillating wildly. As I write (Thursday) the yield on the 10-year treasury is 1.523 percent. But in late February it was 1.61 percent. Volatility in bond yields implies expectations about rate changes. The New York futures markets have priced in a full one percent rate rise in 2022 and two more rises in 2023. 

Third, as the Bank of England’s widely admired Chief Economist, Andy Haldane, outlined in an important speechrecently, the deflationary conditions that kept inflation and interest rates so low for so long are now disappearing.

For a start, what I call the Primark effect, is now all but played out. This was the effect of the first wave of globalisation which brought absurdly inexpensive goods into European and American shops. The T-shirts and fleeces manufactured in Vietnam, the underwear and socks manufactured in Bangladesh, were suddenly available in Primark (owned by Associated British Foods (LON:ABF)) for just a couple of quid. That era is now over as developing countries happily experience rising wages. Indeed, we are arguably entering an era of de-globalisation in which make-at-home strategies will flourish. Food prices globally are on the up. UK trade with the EU is now in free-fall, as I discussed recently. Less cross-border trade is probably better for the environment but also implies higher prices.

Then there is what I call greenflation. As the major economies transition to carbon neutrality the cost of energy will rise. That will inflate the prices of almost everything else. The prices of rare Earth metals (esoteric elements such as scandium and lutetium) used in the manufacture of batteries, electric motors and sensors are also trending upwards. China controls the supply of about 80 percent of these critical elements.

It may well be that be that the global economy will adapt to the new green normal (I shall continue to comment on that here) and that the green economy will be super-efficient. But the transition process is likely to be costly.

UK house prices

According to the leading British estate agency, Savills, house prices will accelerate further upwards this year. The vaccination programme in the UK will have inoculated all adults by late July and the lockdowns will be unwound by early summer. Whereas the agency had predicted zero growth for 2021, it now foresees an uplift of four percent, having risen by 7.3 percent last year. That is partly due to the extension of the stamp duty holiday (on properties of up to £500,000) until July. London is the laggard, with a new trend of de-population as immigrants head home and others leave for the country – although “prime” (i.e. top-notch) property will rise strongly. Regional growth will be led by the northwest – up by a stonking 28.8 percent over the next five years.

In the past house (and other asset) prices have absorbed and to some extent disguised the monetary stimulus facilitated by the central banks. That’s fine if you already own a home; but not so good if you want to get on the housing ladder for the first time.

Inflationary advantage

There is one school of thought which maintains that inflation is not such a bad thing after all. For those in debt, inflation reduces the relative value of that debt. Homeowners of my generation know well how rising house prices over time make their mortgages look modest. Similarly, highly indebted governments might even see a lowering of their debt-to-GDP ratios even as the cost of servicing that debt explodes.

For those in debt, deflation is the real terror. That happened in the US in the late 19^th century when people who had borrowed heavily to buy farmsteads found that the value of their assets had plunged, and their debts became unsustainable. That gave rise to the populist movement under William Jennings Bryan, and the campaign for a silver standard. As I have speculated in these pages before, widespread deflation could occur once the global population begins to decline perceptibly – but that’s not likely to happen before mid-century.

Pension funds would also be able to reduce their deficits as fixed income holdings yield more and the value of pension liabilities decline (because the discount rate increases). But if a gradual rise in rates and government bond yields might benefit some, a sudden jump could be highly disruptive.

The once understood sensitivities of interest rate movements versus debt and stock price changes are probably obsolete. It does not follow that stock prices would automatically fall if and when rates rise. The standard model says that, if stocks are worth simply the discounted net cash flow derived from holding them, then a rise in the discount rate (ultimately derived from the debt markets) will reduce their value. But stock prices have a tendency to defy such models.

And emerging markets have borrowed exorbitantly in dollars and euros that were easy to service. What would happen if the developed world and the developing world went bankrupt at the same moment? Saxo Bank recently warned of the Tesla-Bitcoin-Ark risk cluster. Ark refers to Ark Invest, the momentum ETF which was down by 18 percent earlier this month. 

Most concerning of all is that Mr Sunak and his fellow finance ministers have no Plan B for what would happen if the wolf came prowling. Normally calm people have the right to worry when they hear that distant howl.