Often, we can be right for the wrong reasons. So it is with those who a few months ago were worried about inflation.
It’s now likely that CPI inflation will exceed 8 per cent in the spring, a 30-year high. This isn’t to say it will stay high; the fact that wages are not keeping pace with inflation (latest figures show they rose 4.8 per cent in the year to January) suggests there’ll be no wage-price spiral. But the fact is that the inflation pessimists were right.
Many, though, were right for the wrong reason. Conservative MP John Redwood says: “the Bank of England printed too much money to cause the inflation.” True, households’ bank deposits have increased markedly, by 18.8 per cent or £279bn in the past two years. But this did not cause inflation.
To see why, ask the crucial question in all economics: what’s the mechanism? In theory, it is simply that when people find themselves holding too much money they’ll spend more, and this increased demand drives up prices.
Now, this has explained some inflations, such as that of the late 1980s. But it doesn’t explain the current one. If it did, we’d now be seeing a consumer boom. Which we are not: retail sales volumes are lower than they were last spring and have risen only 3.2 per cent in the last two years, a slower rate of growth than in the previous ten years. And inflation is heavily concentrated in a few areas. Just three (home heating, used cars and petrol) account for 2.3 percentage points of the 5.5 per cent inflation we saw in January.
The monetarist theory of inflation envisages people thinking: “we’ve got more cash that we expected; let’s buy a new TV or nice holiday”. Which is plausible. What’s less plausible is people responding to high money balances by turning the heating up, but this is where the inflation is.
We’re not seeing high inflation because of excess money growth. We’re seeing it because of soaring oil and gas prices, allied to perhaps short-lived mismatches between the patterns of supply and demand and Covid-induced disruptions to supply chains and inventories. Many who feared inflation were therefore right, but for the wrong reason.
So too were those who bought gold as protection against inflation. Gold hasn’t risen because of fears of inflation: the link between it and inflation expectations has long been weak. It’s risen because of global uncertainty caused by Russia’s attack on Ukraine, which few saw coming.
Being right for the wrong reason is, however, common. Of the few people who foresaw the 2007-08 financial crisis most talked of the danger of global imbalances rather than the fragility of the banking system. Investors who avoided Russian stocks on ethical grounds have avoided big losses without being right as to why. And countless bullish or bearish calls on equities down the years have been right for the wrong reasons.
But what’s so bad about being right for the wrong reasons?
In one regard, nothing at all. In fact, it’s sometimes better than being right for the right reasons. In the late 1990s, some investors avoided tech shares believing them to be over-valued – most famously the late Tony Dye. They were right, but at the wrong time and so missed out of months of profits; Dye lost his job. Similarly, this year’s fall in US equities seems to have vindicated those who thought the market over-priced. But many believed this for years and so missed big profits.
Being right for the right reasons at the wrong time is useless. It’s better to be right for the wrong reasons at the right time.
But it’s not wholly correct though. The problem with those inflation forecasts was the same as with most macroeconomic and market forecasts. It’s the narrative fallacy. Telling a story gives an illusion of knowledge and encourages us to believe that the world is more predictable than it actually is. And if we don’t acknowledge that our reasons were wrong, we are likely to persist in this illusion and become overconfident.
This approach – which of course was shared by those who didn’t foresee rising inflation as well as those who did – misses a crucial point made by the political scientist Jon Elster: that sometimes we can predict without being able to explain, or explain without being able to predict.
Take for example medium-term returns on UK equities. These have often been predicted simply by the dividend yield: a high yield predicts rising prices and a low yield falling ones. This isn’t perfect: it failed to foresee the Covid-induced fall in prices in 2020. But there is predictability. What there is not, however, is a story. Lead indicators can sometimes tell us that the market will fall, but they cannot tell us why. And sometimes, nothing can.
And we don’t need to know: even a moderately accurate lead indicator is useful enough.
We must therefore heed Charlie Munger’s advice and acknowledge the edge of our competence. This edge is not so distant as to encompass macroeconomic forecasts accompanied by detailed stories. We must be humble about our predictive abilities and not rely upon forecasts for investment purposes. Instead, we must simply hold diversified portfolios that will hold up in most possible futures.
