Join our community of smart investors

Inflated expectations

Imagine an amoeba in a sci-fi horror. One moment it’s barely a speck in the Petri dish; next moment, it has taken over the laboratory. That, if you like, is the ghastly caricature of inflation feasting on itself, whereby inflation begets inflation in a pernicious feedback loop that somehow gets going comparatively easily in the UK. Thus, goes the fearful thought, who knows what longer-term effects may be caused by the UK’s current rate of inflation rising at 3 per cent, triple the pace at which it started 2021?

But, actually, should economists in general, and those at the Bank of England in particular, be so obsessed that once higher inflation gets hold still more follows in a self-sustaining process? The logic is that in wage bargaining, pay settlements are forced upwards by employees’ representatives worried that inflation will accelerate. Thus the very rise in inflation that was feared becomes a reality and so on.

Right now that fear is ubiquitous and you can understand why. Among the G7 group of the world’s biggest democracies only Italy has a worse record than the UK for controlling inflation. Apart from possible damage to monetary policy, rising inflation damages livelihoods in the real economy.

 

 

Even from the perspective of investors, the implications for securities’ values are mixed at best. At the very least, the more that inflation rises, the higher the hurdle rate of return that a portfolio must hit before its returns become real. Meanwhile, the price of securities whose value depends on a fixed flow of payouts must get depressed and some equities fare better than others, largely depending on the ability of companies to offset their rising costs without damaging demand too much.

However, according to a paper this month from Jeremy Rudd, an economist at the Federal Reserve System, the US central bank, the conventional wisdom that inflationary expectations cause inflation to rise in the future chiefly rests on lazy thinking. Put simply, there is a tautology at work – inflationary expectations are assumed to be important because they have always been assumed to be important; or at least since 1968 when Milton Friedman assigned a role for them in shaping the trade-off between wages and employment in the highly influential equation known as the Phillips curve.

Yet, one problem is that, almost by definition, expectations are elusive. Rudd quotes another economist, Robert Solov, from a 1979 paper, 'What we Know and don’t Know about Inflation': “I’m always a little dubious about an appeal to expectations as a causal factor; expectations are by definition a force that you intuitively feel must be ever present and very important but which somehow you are never allowed to observe directly.”

No matter that you couldn’t see inflation expectations, it was sufficient that eminent economists said they were there. Friedman’s work – and that of others – was based on the idea that there is a divide between the side of the economy that deals in ‘nominal’ prices, where knowledge of inflation is somehow absent, and the ‘real’ economy, which is streetwise and deals in inflation-adjusted quantities. Consumers, employers and employees can swan along on the nominal side in blissful ignorance for a while, but sooner or later reality dawns and their attention will shift to the real side. That’s when self-interest means that inflation expectations get to work – there is no point in negotiating a pay settlement that takes no account of where prices may be in, say, 12 months’ time.

Combine that plausible thought with the sustained increase in inflation during the 1960s and 1970s, which seemed to be consistent with the message of the Phillips curve that full employment – and bargaining power – would bring rising wages and, according to Rudd’s paper “these developments were seen as a stunning victory for the prediction that expected inflation was an important determinant of actual inflation”.

Later, in the 1990s and beyond, for central banks, which had a mandate to control inflation, monitoring and managing expectations became a major part of their job. The fact that, for many years from the late 1990s onwards, inflation remained subdued indicated that the bankers were right to focus on expectations and were doing their job well – impressions that they were only too happy to foster.

However, Rudd suggests that self-deception was at work. The presence of expected inflation already in models endorsed by influential economists was the chief justification for the view that expectations really do affect prices. His sardonic conclusion is that this “apotheosis has occurred with minimal direct evidence, next-to-no examination of alternatives that might do a similar job fitting the available facts and zero introspection”.

Besides, he offers the salient point that in the US at least, where unionised industries account for only about 6 per cent of employment, a formal wage bargaining process doesn’t really exist anymore. Instead, he suggests that, while inflation remains subdued, it is only a minor concern for employees. So there are few attempts to leapfrog anticipated inflation by negotiating fatter pay deals. By and large, it is satisfactory that annual settlements are measured in relation to current rates of inflation.

Yet studies from the 1970s suggest there are levels of inflation that do change the perspective, that prompt negotiators to peer further forward. One such study indicated this happened when the rate of general consumer price inflation crossed 3 per cent or when food-price inflation hit 5 per cent. True, such levels have been exceeded from time to time in the past 25 years without a sustained wage price spiral being spun into action, the most damaging period being when inflation remained stubbornly high in the wake of the 2008-09 US sub-prime mortgage crisis. The best-guess explanation is that employees reckoned – or had little choice but to assume – that price rises would return to a long-run average.

In a diluted form, what applies to the US probably applies to the UK. So where does this leave us? The chart below offers mixed messages. First, the line showing the pace at which employees’ earnings have risen is interesting but not that instructive. Changes in earnings are not changes in pay settlements. The former are much more volatile, being linked to economic activity. Thus, year on year they briefly went negative in mid-2020 and are currently rising at their fastest rate in the 21st century. Changes in wage settlements are much more sedate. A year ago, according to XpertHR, a consultancy, the median settlement across the whole economy was just 1 per cent. In August it was 2 per cent. While it had doubled, it was lagging UK consumer price inflation by a percentage point. The question is to what extent that gap will close further, driven by labour shortages.

Listen to the pessimists and the UK’s supply-side difficulties will persist, leading to inflation, as measured by the consumer price index (CPI), exceeding 4 per cent by the end of the year. Already, the prices of almost a quarter of the CPI’s basket of goods are rising by more than that rate.

The conventional view is that this must stir expected inflation, adding further upwards pressure into the mix. Be that as it may, Rudd’s suggestion is that the best that central bankers can do is keep quiet about expected inflation; the more they bang on about it, the more that they foster the outcome they least want. Think of it in terms of that sci-fi metaphor with which we started. Eventually the boffins realise the amoeba only grows when it knows it’s being talked about. Solution – shut up.

_________

Results from pubs operator JD Wetherspoon (JDW) are always entertaining thanks to the thoughts of founder and chairman Tim Martin. This year’s figures were no exception. Martin sounded off about his usual pet hates, one such being the UK’s corporate governance regime. True, a system designed to give the impression of virtue must always be suspect. It aims to bring rigour to the way companies are commanded but equally functions as a cover for rent extraction by directors. When all the boys and girls come from the same school and mark each other’s homework what else would you expect?

Martin’s particular bugbear is that corporate governance rules encourage a churn of non-executive directors. He says this undermines successful businesses by culling those experienced directors who understand a company’s ‘DNA’. His solution is to promote worker directors to Wetherspoon’s board because, as he told The Times, “the knowledge of experienced managers vastly exceeds my own”. Perhaps.

However, there is a wider point underlying Martin’s intentions. The pool of capable people who could do a job as a non-executive director is arguably deeper than conventional wisdom allows. Possible proof of this comes from the increasing number of women non-executives in the past 15 years. Sure, the process has been driven by box-ticking, but – so far as one can tell – it hasn’t lowered the standard of corporate governance; this, despite the inconvenient fact that the CV of the average female non-executive is less impressive than her average male counterpart. Of course this is a function of past practices and prejudices – men usually got the better jobs. So raising the number of women non-executives means the quality of CVs has been diluted even though the quality of appointments has not (so far as we can tell).

Yet the wider point is that this logic won’t only apply to would-be female directors. There are lots of people out there – of all shapes, descriptions and CVs – who are well capable of fulfilling the non-executive role. And it’s not even about diversity per se; it’s about getting better results for companies. Sprinkling the process with worker directors will surely do no harm.

bearbull@ft.com