When will the inflation balloon crash?

Inflation has now reached a 40-year high of 9% and is expected to reach 10% this year.

Hitting double digits this summer seems like a big step, and one that would take us back to the 1970s*, a time poorly remembered by older people who associate that period with endless union strikes and piles of trash. in the streets.

Anything close to a repeat of the situation would put more pressure on the Bank of England – and the UK government – to “act” on the cost of living increases, even though most Inflationary pressures are global.

For its part, the Bank of England begins to resemble the onlookers of the opening scene of Ian McEwan lasting lovewho watch the ball go higher and higher and become more and more frantic at the idea of ​​knocking it down.

Can inflation really be brought down to earth with conventional monetary tools? Or is it just to leave it alone and wait and see?

The Bank of England’s quarterly charts give an idea of ​​the direction of various economic phenomena. It forecasts 13 quarters ahead, but incorporates uncertainty parameters in the form of fan charts (see above).

In its chart notes, the BoE says:

“Considerable uncertainty surrounds the published projections for CPI inflation, unemployment and GDP growth. This uncertainty is reflected by the presentation of the projections in the form of fan charts. The fan chart shows the Committee’s view on uncertainty at specific points during the forecast period.”

Those who worry about inflation can assume the following: in extremis, CPI inflation could reach 12% this year. But the chart shows a quick and reassuring return to 2%, which all too conveniently happens to be the Bank’s inflation target. This was fixed in December 2003 (on a measure of the CPI).

Compare the chart above to one produced exactly one year ago (see below).

CPI Forecast May 2021

In this chart, the numbers are different – ​​completely different. The CPI does not even reach 5% in the most hawkish scenario. And the shape is different too.

So why does the Bank of England expect inflation to fall to target next year? In the “plain English” version of its May monetary policy report, the Bank revisited some of the arguments used by the “transitional team”, before some of the frightening imprints of inflation began to appear. Supply chain issues will be resolved, she predicts, and lower demand (as the economy slows) will take some of the heat out of the economy.

“We don’t expect the causes of the current high inflation rate to persist,” he said.

“Prices for energy and imported goods are unlikely to continue to rise as rapidly as they have recently. We also don’t expect demand for goods to continue to rise as rapidly, and we expect some of the production difficulties companies are facing will ease. We expect inflation to be close to our target in about two years.”

Of all the assumptions here, the suggestion that energy prices (which are a key driver of the global inflationary shock) will pull back so sharply is the most controversial.

Much depends on Russian natural gas supplies to Europe and the state of the war in Ukraine. A cold winter in 2022-2023 could really reveal the fragilities of our energy complex, which has not had time to adapt to the new world order inaugurated on February 24 of this year. In the UK, Ofgem will revise its energy cap again in October, having initially done so in April, a move that has led to a price spike.

Yet, away from the headline figure, there could be signs that inflation is already starting to ease. Ed Smith, co-chief investment officer at Rathbones, sees signs of falling so-called “underlying inflation”, which wipes out energy and food costs because they are so volatile .

“A lot of inflationary pressures are still building in some sectors, but inflation in others, especially basic goods, is coming down significantly,” he said.

“The next few months are going to be crucial, but a return to durable goods [like cars and furniture] inflation from very high rates to more normal/negligible rates is crucial for the current inflationary episode to ultimately prove transitory.

Of course, food and energy inflation tends to hit the poorest hardest, as these are things people cannot avoid paying for.

What are interest rates for?

Central bankers have not faced such inflation for many decades. They have had to deal with multiple crises, like Brexit, the pandemic and now war, but their response has largely been to cut rates and increase quantitative easing to flood the economy with money.

Lower interest rates may have helped cushion the blow of the financial crisis – and the 2020 pandemic – but it now looks less effective on the other side.

Don’t be fooled though. The Bank of England makes the link between rates and inflation simpler than in real life.

“The main tool we use to bring inflation down is to raise interest rates,” he says.

“Higher interest rates make it more expensive for people to borrow money and encourage them to save. This means that, overall, they will tend to spend less. If people as a whole spend less on goods and services, prices will tend to rise more slowly, which lowers the rate of inflation.

Interest rates were raised to 1% in May 2022. Even assuming they will rise further this year, we could have a CPI of 10% or more and base rates of 1%. Of course, interest rates should not get close to the CPI, and that would undoubtedly be counterproductive: the last time rates were this high was in the early 1990s, a period recession that has seen massive job losses and repossessions of homes. (The base rate was increased to 14.88% in October 1989.)

Policymakers know that such high rates would likely trigger the implosion of the consumer economy, which relies on cheap car loans, mortgages and credit cards. And a chart of longer-term interest rates shows that, while we’re in scary territory, we’re a long way from the 1970s, when the RPI hit nearly 27% – and indeed, in 1980, when it exceeded 20% before falling in the rest of this decade.

Big Data meets the future

What can we learn from this fear of inflation? The first is that economic forecasting is a perilous task and investors probably cannot rely on forward-looking forecasts when making decisions. The data is multiplying every year, but still struggling to make the future.

The other lesson might be that we expect too much of institutions like the Bank of England to control our destiny via something as drastic as a base rate change. Fiscal and monetary policies have combined forcefully to “kitchen sink” the response to Covid-19, but that could be a rarity. We don’t know when this balloon of inflation will come down, but maybe we should be grateful that gravity will win out eventually, even if it takes a recession for that to happen.

Finally, it should be noted that the UK has changed its official measure of inflation over the past few decades. The NSO favorite the CPIH measure, which includes homeowner housing costs. It was 7.8% in April, lower than the figure of 9% reported in the media. The RPI, which is no longer used as the preferred measure of inflation, is already above 11%. I last watched this question of what’s in inflation in “The Great Inflation Review”.