There’s nothing certain in the great inflation debate

Published in The Sunday Times on October 2nd 2022

One of the most important principles for writing financial market commentary is to use the word "never" or “always” very sparingly. After all, it takes only a single exception, to falsify an assertion that something "never" or “always” worked or happened. 

The current inflation debate – what’s driving it, how best to respond and whether the genie can be returned to its bottle – has polarised opinion and generated much debate. There is however, a worrying degree of certainty on the various sides of the argument.
 
Our understanding of the appropriate response to bring inflation back to tolerable levels will continue to evolve. With advanced country Gross Domestic Product (GDP) and employment below trend at a time of high inflation and tight labour market conditions, there are very few parallels for today’s predicament. Certainty has no place.   

Financial Times columnist, Tim Harford, provides a very useful distinction between the various views of inflation and its likely causes.

In what he calls ‘Inflation World’, there’s too much money around. Everything is getting more expensive at varying rates, including labour. With wages rising at the same rate as prices, the situation is inconvenient, but not a crisis. Solving this type of inflation problem rests with central banks.

In what he terms ‘Energy Crunch World’, the cost of energy rises rapidly, driving the overall inflation rate upwards. Using the terms of Milton Friedman’s definition of inflation, the increase in prices is not “steady”, it’s not widespread, and it is unlikely to be “sustained”.

There are elements of both in the current environment, so confusion is inevitable. We are dealing with a temporary but very painful increase in the real cost of energy and food but have also seen broader increases in prices – as higher energy prices raise the prices of essentially everything. The two sources of higher prices require quite different policy responses, however, and this is where the debate becomes quite polarised.

The following is a recent tweet from former secretary of the US treasury, Larry Summers - “I'm aware of no major example in which the Central Bank reacted with excessive speed to inflation and a large cost was paid”. Summers carefully leaves himself with an exit should the need for backpedalling arise with equivocal words like – major, excessive, and large – but his overall sentiment is one of certainty. 

In this world, interest rates and the unemployment rate would have to increase significantly and the prospects of a soft-landing essentially round to zero, as Jerome Powell has recently conceded.

If today’s high prices are being driven by specific supply-side dynamics, an interest rate tool that only targets demand will prove very blunt. Those taking this view, amongst them Michael Spence, an economics Nobel laureate, view trade and investment as having long enabled supply to expand rapidly in response to growing global demands.  The recipe in this world is reducing trade barriers, improving productivity (through accelerating digital transformation) and streamlining regulatory regimes to reduce supply-side bottlenecks.

In the ‘Inflation World’ according to Summers, there will inevitably be more pain in both bond and equity markets. The ‘Energy Crunch World’ has more benign financial market implications in the near term at least but would mean greater tolerance for inflationary bursts and disinflationary dips.

What’s clear in this inflation debate is that inflation uncertainty is much greater now than it has been for forty years. 

Investment historians will recall the 1970s as a decade of high inflation, which it was (averaging 7.8% annually in the US). At the start of that decade, investors had no reason to believe that they were heading into a decade of higher inflation. Expected inflation lagged actual inflation through much of the decade, with particularly damaging consequences for financial asset returns. Inflation moderated in the 1980s but remained high (averaging 4.7% annually in the US), but actual inflation undershot expectations as they had caught up with reality. The 1980s was a stellar decade for financial market returns. It’s not clear that unanticipated inflation causes as much damage as high inflation itself, but unarguably inflation uncertainty exacts a toll on financial markets. 

The pillars of the globalised, low inflation world we have inhabited for over a generation, have been weakened by the economic war between China, Russia, and the US/EU. With central banks that are focused on fighting inflation rather than supporting growth, this presents quite a change to the backdrop for investing. Inflation uncertainty remains high, but inflation expectations have risen fairly materially over the past twelve months. And this has already exacted a toll on financial markets.

For assets we have long considered to be safe – cash and bonds – the dangers are real. These assets traditionally provide certainty of return (or at least greater certainty) but not safety. Certainty of return is going to be expensive in a higher inflation environment. Safety is to be found in assets that protected against rising prices, like equities and real assets. 

Before you make any investment decisions, start by asking the right questions. Seek certainty elsewhere. It has no place in financial markets. 

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on twitter @gconno1.