9 June 2021

The beast of inflation is stalking the land again

This is a dangerous moment, not just for central bankers but for the wider economy.

Internet searches for the term “inflation” have picked up sharply this year. But it is not just social media platforms where inflation is trending. In financial markets and among businesses, inflation has emerged as the new narrative and, for some, a key source of concern. After half a century during which it has slept quietly, inflation has re-emerged blinking into the post-pandemic light.

The stakes are high when it comes to keeping inflation low and stable. High for central banks with a mandate to keep inflation in check. High for financial markets where assets are priced for a prolonged period of inflationary somnolence. High for companies and consumers, who would bear the brunt of a rising cost of doing business or living. And high for governments that have borrowed big to cushion the Covid crisis and whose borrowing costs would then assuredly rise.

In the midst of a global pandemic, uncertainty around future inflation paths is, of course, unusually great. For example, no one could reasonably predict with any accuracy what course the virus might take next and its implications for the pace of opening up, in the UK and internationally. And there remains a risk a mutant, vaccine-resistant strain could scupper the best-laid plans of governments, businesses and households, suppressing spending and inflation.

But, in my opinion, these risks are no longer squarely skewed to the downside. Indeed, I believe the balance of risks has shifted decisively over the past few months. A rapid resurgence in both spending and inflation is now a plausible central scenario for a growing number of businesses and economists. This case needs to be understood, monitored and potentially acted on by central banks if the inflation genie is not to escape after a half-century of captivity.

Most people agree that, as vaccine programmes are rolled out and restrictions are loosened, the economy will bounce back relatively rapidly towards its pre-Covid base. An atypically sharp fall in the economy, as restrictions were put in place last year, ought to be mirrored in an atypically sharp recovery as restrictions are lifted. For that reason, and virus and vaccine developments notwithstanding, a third “V” – for the shape of the economic recovery – was always on the cards.

Recent economic indicators in the UK, with very few exceptions, suggest the recovery is happening at least as fast as any mainstream forecaster was expecting. We can see that in increased traffic on the roads, footfall in the shops and bookings in the pubs and restaurants. Retail sales spending, housing transactions, private car sales, surveys of consumers and companies, restaurant bookings, job vacancies – all have already recovered to at or above their pre-Covid levels.

This resurgent demand is bumping up against a supply side of the economy slowly re-emerging after more than a year of forced inactivity, businesses paused, workers furloughed. Faced with an imbalance between surging demand and slow-moving supply, the laws of economic gravity suggest prices should rise. And so they have, across almost all commodities and assets and at real pace. Since the start of the year, the price of oil has risen by over 30 per cent, gas 10 per cent, copper 26 per cent, US lumber 50 per cent, food 17 per cent and houses by more than 5 per cent.

If you speak to businesses, the list of items whose prices are now rising has lengthened, and the price rises themselves have steepened, as the year has progressed: from concrete to bricks to chips to plasterboard. This is clear in the data too, with the cost of business inputs in the UK currently running at its highest level since 2008. These pipeline price pressures are now working their way through business supply-chains, with companies’ output prices rising at their fastest rate since at least the mid-1990s.

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Rises in the cost of business inputs, caused by a one-off bounce-back in demand and temporary bottlenecks in supply, are not by themselves a cause of acute inflationary concern. Rises in input costs may be absorbed in companies’ margins rather than being passed through to end consumers, or offset by squeezes in workers’ wages. In either case, the rise in inflation would be temporary and the challenge for central banks, governments, business and households much reduced.

But there are plenty of reasons why that benign inflation scenario may not materialise. The momentum in demand may prove persistent rather than one-off. Bottlenecks in supply may prove sustained rather than fleeting. Pricing power among companies, and bargaining power among workers, may be bolstered by resurgent demand rather than remaining low. While nothing is assured, I believe the evidence on each is mounting in one direction.

Let’s start with the recovery in spending. The recovery after the global financial crisis was a faltering one as three significant headwinds combined: psychological scarring of people’s risk appetites and animal spirits; financial scarring due to the holes blown in banks’, companies’ and households’ balance sheets; and fiscal scarring as the UK government sought to repair its own balance sheet. This triple scarring made for an anaemic recovery.

Today, none of these headwinds is present. Indeed, each is now potentially a tailwind. Although it is early days, sentiment among businesses and consumers has already shifted decisively, with company and household confidence climbing to above pre-Covid levels. Psychologically, although obviously not true for all, most people seem keen to make up for the lives they have not been living for the past 15 months, with huge pent-up demand for holidays, hospitality and other types of social spending.

By comparison with most recessions, aggregate financial balance sheets are also strong. Forced saving during the pandemic means that, unlike in 2008-09, large cash-piles have been accumulated, totalling around £200bn among households (15 per cent of annual consumption spending) and over £100bn among companies (half of annual investment spending). These accidental savings provide the financial fuel to fire people’s spending desires.

As for fiscal policy, what a difference a decade makes. Fiscal deficits across advanced economies currently stand at 15-30 per cent of GDP, with the UK towards the bottom of that range and the US towards the top, as governments serve as emergency-responders to the Covid crisis. A new fiscal orthodoxy has emerged with debts and deficits now seen as a force for good in wartime and, potentially, peacetime too. This orthodoxy is being led by the Biden administration in the US, which has a further $6trn in the fiscal pipeline for peacetime, to accompany the $6trn of rescue response that it has so far spent to fight the Covid war.

All of this provides good grounds for believing the surge in demand currently under way will persist, not fade, with time. My best guess is that the UK economy will move from bounce-back to boom without passing “go”, as cash is splashed and the holy trinity of animal spirits, buoyant balance sheets and fiscal pump-priming combine. Although we have no historical case law to guide us, the collective psychology of the nation will, I suspect, switch from low-level anxiety to exuberance.

If so, what will be the response from the economy’s supply side? Can it flex in response to resurgent demand in a way that limits price rises? Initial indications are not encouraging. Bottlenecks have very quickly emerged, not just in commodity markets but in the jobs market too, despite millions of workers remaining on furlough. Reports of skills shortages are rising and broadening across the economy, ranging widely across the skills spectrum from technology to distribution to hospitality. Where skills shortages lead, wage rises tend to follow: lorry-driver pay is reportedly up 20 per cent on the year.

It could be argued that these are the inevitable teething problems associated with opening up after lockdown, as businesses and workers adapt, gingerly, to a rapidly growing economy. But that, I think, underestimates the scale and duration of the challenge ahead. The economy will emerge from this crisis in a different, perhaps very different, sectoral shape than it entered. Air stewards and shop assistants cannot instantly retrain as bricklayers or IT experts. Skills shortages will persist.

These Covid-related frictions are being amplified by longer-term forces pushing in the same direction. For several decades the UK and other countries were a beneficiary of globalisation and demographic trends. Free flows of international goods and people increased the supply capacity of the UK economy, reducing the price and increasing the quantity of both goods and workers. Indeed, these forces were key drivers of the global disinflationary down-draught of the past half-century.

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Those trends, in the UK and elsewhere, have now stalled or even reversed. The forces supporting globalisation have been subject to a challenge given impetus by the Covid crisis and, in the UK, Brexit. The latter is already having a marked impact on the supply of EU labour, adding to staff shortages across sectors from agriculture to health to IT. At the same time, longevity trends have gone from tailwind to headwind as more of the UK workforce retires – the nation’s workforce has been falling for a decade.

If resurgent demand meets shrinking or static supply, the laws of economic gravity mean persistent price pressures will be hard to escape. Booming consumer demand gives companies pricing power to pass on cost increases to consumers. And tightness in the jobs market gives workers bargaining power to increase wages over and above rates of inflation. If wages and prices begin a game of leapfrog, we will get the sort of wage-price spiral familiar from the 1970s and 1980s.

Any rise in inflation will not be on the scale of the 1970s or even the 1980s. Since then, we have dug much deeper institutional foundations, with inflation targets and central bank independence set in statute. But even muted wage-price spirals could leave inflation well above target for a protracted period. And the longer that above-target period lasts, the greater the risk inflation expectations are de-anchored, adding to inflationary persistence. In financial markets, inflation expectations have already nudged up above their average levels in the inflation-targeting era.

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Of course, nothing about this upside scenario is certain, any more than there can be confidence the rise in inflation will be temporary. But policy is about balancing risks and these have shifted swiftly, significantly and decisively in an upward direction since the start of the year. This makes it a dangerous moment, not just for central bankers but for the wider economy.

Indeed, in my view this is the most dangerous moment for monetary policy since inflation-targeting was first introduced into the UK in 1992 after the European Exchange Rate Mechanism debacle. During the Covid crisis, central banks have followed the same playbook as after the global financial crisis: a large and rapid crisis was met with a large and rapid monetary policy response. But after the global financial crisis, the economy recovered slowly so monetary policy was normalised slowly.

This time is very different. The economy is rebounding rapidly. Yet the guidance issued by central banks implies a path for policy normalisation every bit as sedate as after the global financial crisis. Having followed the global financial crisis playbook on the way in – rightly – there is a risk central banks also follow it on the way out. This would be a bad mistake. If realised, this risk would show up in monetary policy acting too late.

Friedrich Hayek once referred to inflation as the tiger whose tail central banks hold, usually with trepidation and ideally from a safe distance. If central bankers wait to see the whites of this tiger’s eyes before acting, they risk having to run like the wind to avoid being eaten. Waiting too long risks interest rate rises that are larger and faster than anyone would expect or want. It runs the risk of the brakes needing to be slammed on to an overheating economic engine.

No one wins in that situation. Not central banks, whose mandates will have been breached and which would need to perform an economic handbrake turn for which they would not be thanked. Not businesses, for whom a higher cost of borrowing and a slowing economy would, with debts high, be an unwelcome surprise. Not households facing the twin threat of a rising cost of living and a rising cost of borrowing. And not governments, whose debt servicing costs would rise, potentially casting doubt on their capacity to run big debts and deficits. Ouch.

The policy lesson is a clear one, and an old one. The inflation tiger is never dead. While nothing is assured, acting early as inflation risks grow is the best way of heading off future threat. This is monetary policy 101. As experience in the 1970s and 1980s taught us, an ounce of inflation prevention is worth a pound of cure.

Latterly, the Covid crisis has taught us the same lessons about the severe costs of imposing restrictions too late in the day to suppress an imminent threat. These lessons, old and new, are ones economic policymakers the world over now need to act on.

Andy Haldane is the chief economist at the Bank of England