Inflation will rise. Although the rise in import prices caused by sterling’s fall will be mostly absorbed by manufacturers and retailers, not all of it will be. As result, as Bank Governor Mark Carney warned last week, consumer price inflation is likely to rise above its target next year.
Some people think this is good news. As inflation rises, real interest rates will fall and lower real interest rates should boost the economy, shouldn’t they?
No. M&G’s Eric Lonergan suggests one reason why not; at very low interest rates, he says, savers will save more in an effort to top up their lost income and this offsets the normal effect of lower rates in stimulating borrowing.
But there’s something else. Higher inflation in itself tends to reduce consumer spending.
One fact tells us that - that there has traditionally been a statistically significant positive correlation (of 0.19 in quarterly data since 1964) between the inflation rate and the household savings rate. Higher inflation is associated with consumers spending a smaller proportion of their income. For example, as inflation rose in the 1970s so too did savings, despite the fact that higher inflation caused sharply negative real interest rates. And as inflation fell in the 1980s, so too did savings rates, even though real interest rates rose. And in the 00s, low inflation was accompanied by low savings.
There are four reasons why inflation should depress consumer spending:
- It imposes losses on non-interest bearing cash such as current accounts and notes and coins. And there are a lot of these. The Bank of England says there are £71.3bn of notes and coins and £1.54 trillion of overnight deposits, many of which pay no interest. In this sense, inflation makes people worse off. And if folk are worse off they'll spend less.
- Inflation creates cashflow trouble for some people. As Dr Carney said, the poor might be hardest hit by higher inflation as they spend a bigger proportion of their incomes on food. But the poor have fewer savings to run down and are less able to borrow (except on extortionate terms). They might therefore cut the volume of their spending as prices rise. It's hard to see why the better off should raise their spending to offset this.
- Inflation is usually associated with increased uncertainty - partly because higher inflation is usually more volatile inflation, but also because inflation is a sign of economic and political instability. And, naturally, uncertainty reduces spending.
- Our spending decisions are influenced by perceptions of fairness: we obviously hate being ripped off. And here’s the thing. Holger Herz and Dmitry Taubinsky have shown that our perceptions of what is a fair price are shaped by the prices we’ve become accustomed to. This poses the danger that as prices rise more quickly than we are used to, we’ll regard more of them as rip-offs and so we’ll spend less.
For these reasons we should not take comfort in the fact that higher inflation will reduce real interest rates. The idea of "the real interest rate" is too simplistic. Inflation of two per cent and a nominal rate of zero and inflation of 10 per cent and a nominal rate of 8 per cent both give us the same real rate. But there’s no reason to suppose that the behavioural effects will be the same in both cases. Quite the opposite.
Equity investors should worry about this. If inflation holds down consumer spending whilst a tight labour market supports real wages, then profits will be squeezed; brute maths tells us this. My concern is that this is not yet fully factored into share prices.
Again, one big fact corroborates this. It’s that there has, historically, been a tendency for high inflation to be associated with higher dividend yields: shares, remember, did terribly in the 70s.
Now, we’re not returning to the levels of inflation we saw then. Nevertheless, the fact remains that both history and theory tell us that higher inflation isn’t good for investors.