If inflation is too much money chasing too few goods, it is about to rise.
This is because the pandemic has seen a big rise in the money stock. Since the end of 2019 the M4 measure of it (which comprises the bank deposits of households and non-bank businesses) has risen by 15.1 per cent or £379bn in the UK.
A big reason for this is that the government borrowed money to support incomes during the pandemic. Such borrowing tends to raise the money stock simply because when the government spends more than it raises in taxes it puts more money into our hands than it takes out. In normal times, this impact of borrowing on the money stock is cancelled out by the government issuing bonds: when we buy bonds from the government our bank deposits shrink. In the last few months, however, the Bank of England has bought bonds and so government borrowing has indeed boosted the money stock.
But do monetary expansions really lead to higher inflation? My chart suggests: not much. It shows that since the early 1990s we’ve seen big swings in monetary growth but little change in inflation. Nevertheless, there is a link between the two. Faster monetary growth in the mid-2000s and 2016 led to higher inflation a few months later while falls in monetary growth in 1990-91, 2010 and 2017-18 led to falling inflation. If this pattern continues to hold, inflation will rise. Not by much, because big rises in monetary growth are associated with only moderate rises in inflation, but enough to push it above the Bank of England’s 2 per cent target.
What’s the mechanism here? It’s that while people might be happy to hold extra bank deposits for a while – say because uncertainty or lockdowns make them unwilling or unable to spend – they eventually find the money burning a hole in their pocket and so go and spend it. And this rising demand eventually leads to rising prices.
We’re already seeing step one of this process. With 'non-essential' retailers having reopened in April, we have started to spend the cash piles we built up in lockdown. Official figures show that the volume of retail sales jumped by 16.8 per cent between January and April to a record high. And economists expect that total consumer spending this year (which includes not just retail sales but also spending in pubs and restaurants) will grow by 4.6 per cent in volume terms.
Increased demand, however, is not in itself sufficient to generate inflation. What matters is the economy’s ability to supply this demand. If there is enough spare capacity in the economy, demand growth need not push up prices.
But how do we measure spare capacity? One way is to use so-called 'output gaps', which compare the actual level of GDP to its potential or trend level. Many economists, however, dislike this approach. Antonella Palumbo at Roma Tre University says measures of potential output in practice are too sensitive to actual output, which causes economists to underestimate the amount of spare capacity; this is one reason why the ECB has for years overestimated inflation. Robin Brooks, chief economist at the Institute of International Finance, has for this reason launched a campaign against “nonsense output gaps”.
A more direct measure of overall spare capacity is simply the number of people out of work. There are now 1.6m officially unemployed – equivalent to 4.8 per cent of the labour force – plus a further 1.9m outside the labour force who want a job, as well as over 3m people who are in work but not putting in as many hours as they would like.
Recent history suggests this is sufficient to hold inflation down. From 2016 to 2019 the jobless rate fell from 4.8 to 3.8 per cent. And CPI inflation fell in this period. This prompted economists in the UK and elsewhere to wonder whether the Phillips curve (the link between unemployment and inflation) had disappeared.
Which poses the question: if a 4.8 per cent unemployment rate led to falling inflation five years ago, why should it lead to rising inflation now?
It’s because the pandemic might have caused a deterioration in the trade-off between unemployment and inflation so that a given level of joblessness now is associated with higher inflation than five years ago.
One reason for this is migration. Before 2019, rising demand attracted migrant workers into the country: their numbers rose by 1.5m between 2012 and 2019. This helped to overcome labour shortages, enabling the economy to grow without generating inflation. Many of these workers, however, returned home during the pandemic: the Office for National Statistics doesn’t know how many, but Jonathan Portes and Michael O’Connor estimate that it could be over 1m. Which is one reason why some pubs and restaurants are already reporting difficulties in hiring.
Also, prices are held down by competition. And this could decline. Bank of England data show that small- and medium-sized companies (those with turnover less than £25m) have seen their debts rise by 26 per cent in the last 12 months. If this burden forces some out of business, survivors will see less competition and so be more able to raise prices.
Even if high debts don’t force companies to the wall, they could stop them expanding. So too might something else – a scarring effect. In the last 13 years we have seen two of the three worst recessions in history. Given such instability, entrepreneurs could be loath to start new businesses or expand or refit existing ones. For this reason Bank of England deputy governor Dave Ramsden has warned that downturns “have persistent effects on investment, innovation and productivity”. Which means we could run into capacity constraints more quickly than otherwise, leading to inflation.
There’s a further problem. Recessions disrupt patterns of supply and demand – a fact magnified by the changes in behaviour which the pandemic has forced upon us – which causes mismatches between the unemployed and the demands of employers, with the jobless having different skills to those required by the firms that are hiring. These frictions cause inflation to rise early in economic upturns. In 2011 CPI inflation hit 5.1 per cent even though the unemployment rate was over 8 per cent.
Such frictions, however, are usually short-lived. Inflation and unemployment eventually both fall as mismatches diminish – as the unemployed find jobs that are suitable or retrain, thereby alleviating labour shortages. People are smart. They find ways of responding to shortages. The virtue of a market economy is that it enables such responses.
How, then, can inflation persist?
One word: expectations. Higher inflation can lead to expectations of higher inflation. And these can be self-fulfilling. When companies expect prices to rise – which as we explore below is already happening across many commodities – they raise prices themselves in anticipation of costs rising and of their rivals jacking up prices. If customers expect inflation, they’ll tolerate prices rises instead of taking their custom elsewhere. And if workers expect price rises, they’ll demand pay rises to match.
Inflation can therefore feed on itself – as we discovered in the 1970s.
Which is why governments around the world, including the UK, adopted inflation targeting. If people trust the Bank of England to stick to its target of 2 per cent inflation, they’ll expect inflation to stay low and so it will stay low.
But do they trust it?
Not entirely. Since 1999 the Bank of England has surveyed public attitudes to inflation every three months. My chart plots what they perceive inflation to have been in the previous 12 months – which is not the same as official CPI inflation – against what they expect it to be in the following 12 months.
This shows that people do not have 100 per cent faith in the inflation target: if they did, expected inflation would not vary so much as it has.
But nor is there a spiral in inflation expectations. In fact, the opposite. When inflation has been high, people have expected it to fall. And the belief has been father to the fact.
It’s not just the belief, though. The Bank of England can control inflation simply by raising interest rates. Bank economists estimate that a one percentage point rise in Bank rate will reduce inflation (relative to what it would otherwise have been) by a percentage point after two or three years.
This doesn’t mean it will raise rates immediately. It expects inflation to rise later this year simply because of so-called base effects: last year’s low oil prices and cut in VAT on hospitality trades will drop out of the inflation numbers. It says it will only raise rates when it is confident of meeting its inflation target “sustainably”. Which economists and gilt investors interpret to mean that it will tolerate above-2 per cent inflation for a few months.
If the Bank is serious about its target, however, then it will eventually raise rates unless inflation looks like falling back of its own accord – which is possible.
Which poses the question: why, then, should we worry about serious and prolonged inflation?
One possibility is that the government will raise the inflation target to accommodate it.
Another possibility is that if we see inflation combined with high unemployment the Bank will continue to tolerate it in an attempt to support the economy. This, however, is only possible if there are fundamental failures of market forces such as a lack of market competition holding inflation down; inability of companies to find ways of coping with localised labour shortages by boosting productivity or training staff; or inability of workers to fill what vacancies there are.
In this sense, what we should worry about is not inflation but rather what it would be a symptom of – structural failings of the UK economy.
