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OPINION

Tobin’s pie

Tobin’s pie
June 1, 2022
Tobin’s pie

There is probably no better definition of inflation than that suggested by James Tobin, an influential US economist, who said it was a symptom of social and economic conflict where “the major groups are claiming pieces of the pie that together exceed the whole pie. Inflation is the way their claims, so far as they are expressed in nominal terms, are temporarily reconciled”.

Beat that from the economist who gave us Tobin’s ‘q’, a notion dear to investors’ hearts that emphasises the importance of the price-to-book ratio in determining whether companies expand by acquisition or by capital spending.

Anyway, this definition of inflation – let’s call it Tobin’s pie – prompts the thought, what rate of inflation will reconcile the conflict this time? As, indeed, conflict it is – we only have to watch the actions of P&O Ferries or hear the threats of the RMT, the railway workers’ union, to know that. Obviously, investors need a view because at some point, if it isn’t already happening, inflation is likely to erode company profits either by depressing demand, raising costs or both.

Academics in the US have given the matter much thought since US consumer-price inflation led the developed world as it came out of its Covid-induced lockdowns (see chart). Much attention has been devoted to the Phillips Curve, which illustrates the trade-off between rates of employment and inflation. Go back 40 years and economists obsessed over the Phillips Curve, named after an economist at the London School of Economics, but its importance faded in line with declining inflation.

That won’t change, says Jeremy Rudd, an economist at the Federal Reserve Board (the US central bank), comparing today’s labour market with that of the 1960s. “Rather than resulting from successive large boosts to aggregate demand, much of the recent rise in inflation instead reflects a set of relative price shocks,” he says, as supply failed to meet demand.

True enough, though, after the event, governments have been only too ready to take fiscal action to sustain demand and, in effect, to boost it. Witness the so-called CARES Act of March 2020, which gave the US economy its largest-ever state-funded boost (all $2.2 trillion of it); or just last week chancellor Rishi Sunak helped sustain (or boost?) the UK economy by subsidising households to the tune of £21bn. This will add over 7 per cent to the government’s annual welfare spending in response to rising power bills that will be little more than an inconvenience to affluent households. Sunak’s measure may be great for retailers later this year as wealthy pensioners (especially those with second homes) binge their double winter-fuel allowance on extra Christmas spending. Whether it is a sound move in the longer term is another matter.

As the chart shows, the UK now tops the developed nations’ inflation league table and, remember, whatever is the latest inflation rate, it lags reality. Intuitively we know that the current rate – 9 per cent – lags on the downside. We also know that when inflation crosses a threshold – 5 per cent is a fair bet – it starts getting baked into expectations. Inflation begets more inflation.

Match that up with the UK’s unemployment rate – at 3.8 per cent close to a record low – and soon we’ll be obsessing about the Phillips Curve again as workers take more of Tobin’s pie. The likely effect on company profits won’t be much fun for investors but, perhaps, not before time.