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29 June 2021

The Inflation Complication

Following the Bank of England’s decision makers meeting last week, investors were relieved by the message that the interest rate would remain at its record low of 0.1%, despite concerns of a post-pandemic inflation surge. Inflation is indeed a worry for the Bank and the Government as the economy reopens and spending ensues in earnest. But what is inflation, why is it such a worry now, and ultimately, why should we care?

As the dust settled from the Global Financial Crisis of 2008, governments around the world had one of the most challenging economic problems imaginable, how to reignite credit markets to stoke public confidence in spending money again. Seemingly, only one group of institutions could provide the helping hand needed: the central banks. As the monetary authority of the largest economy in the world, the US Federal Reserve (Fed) had the eyes of the world upon it.

In the wake of the crisis, it became clear that savers had lost faith in the banks. At the same time, the banks became resistant to lending money to people who could not afford the interest repayments. In response, the Fed pulled an unprecedented move in slashing the interest rates to record lows, which gave little incentive for savers to keep money in the bank and more incentive to borrow cheaply and spend. To give things that extra boost, and to ensure the banks had enough capital to lend to this new army of borrowers, the Fed started buying government issued bonds from the banks with newly printed money.

Known as quantitative easing (QE), the Fed gave the economy a shot in the arm with its experimental policy and the critics came out in force. Economists feared that an uncapped facility to print money, in tandem with ultra-low borrowing costs, would send the economy out of control and see inflation skyrocketing. Of course, this doomsday situation did not materialise amongst the perfect storm of increasing globalisation and digitalisation, through the rise of the internet and ecommerce.

However, an unintended consequence of the move was the meteoric rise in asset prices, where savers began seeing the appeal of investing to achieve any meaningful return on their money, and expanding companies were able to borrow cheaply to invest in their future growth. With little sign of inflation on the horizon, investors were comfortable in paying a higher price for the future growth of companies that did not turn a profit immediately.

During the height of last year’s pandemic woes, the Fed struck again, turning the QE taps back on and dwarfing previous monetary stimulus from around US$2tn by the end of 2008, to almost US$8tn today. To compound this, the US government have been handing stimulus cheques directly to the American people throughout the pandemic.

Today, we face an inflection point. The critics are out again, and inflation is back on the agenda. This time they are right, of course, as annual inflation in the US has just surpassed 5%. The investment markets are worried. High-growth companies are being rotated by investors into those with more certain and present cash flows, while bond yields have risen to reflect the demand for an inflation-beating return.

But will it be transitory or here to stay? The cyclical forces of the pandemic are certainly not helping; supply constraints, bottlenecks and excess demand for labour are real problems across the world. However, the structural and more disinflationary powers remain; digitisation, increased competition and the reshoring of supply chains should normalise things somewhat once the initial euphoria of spending has diminished. How long for, however, is hard to say.
 
The Inflation Complication
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