5) Do we think a repeat of the 1970s is likely?
No. Inflation is a much an institutional phenomenon as anything else. Today’s institutions are very different. We have inflation-targeting central banks, which have kept inflation expectations further out very well anchored. Longer-term measures of inflation expectations, which are the key to influencing employee’s demands during pay settlements, have actually declined over the last few months. There’s a consumer survey in the US which has been asking the same questions since the 60s. In the 70s, consumers said, ‘inflation is high, we expect it to stay high, so now’s probably a good time to buy a car or a sofa in case it gets even more expensive’. Today consumers are saying, ‘inflation is high, we don’t expect that to continue for long, and so now’s a bad time to fork out because I’m concerned about the purchasing power of my pay’.
Labour market institutions are also very different. Very few employees have contracts where pay rises are linked to inflation. We’ve been keeping a close eye on trade union settlements and their direction. In Germany, where collective bargaining is a matter of course, most industries have settled for real-terms pay cuts. If this pay restraint changes, however, the risk of a 1970s rerun might increase.
6) How is the Bank of England or the Federal Reserve likely to respond to inflation throughout the rest of this year?
In both the UK and the US, interest rate futures are saying that the policy rate will be about 1.5% higher than it is today. So that means 2% in the UK. We take a different view: we think there will be another two or three quarter-point rate rises in the UK over the next 4-6 months, three or four in the US. But we do not expect a full 1.5% of tightening.
That’s particularly the case in the UK. If the Bank were to raise interest rates in the way markets currently expect, it would likely result in inflation falling back to too low a rate in 2023, and, worse, rising unemployment. It should also be noted that these market expectations have regularly overestimated interest rates – twice as often as they have underestimated them.
7) Does the Bank of England increasing the base rate really have much impact on reducing inflation if so much of it relates to energy costs, building materials and food supplies which are insensitive to higher interest rates?
No, not at all. If base rates are 1% instead of 0%, it means very little to the supply of microchips from Taiwan, or the price of oil, and the Bank has been quite explicit about this.
It’s choosing to raise rates because the economy and employment have recovered much faster than it previously anticipated and, because monetary policy takes roughly 12-18 months to fully feed through, it wants to act today to stop the economy running too hot later on, and inflation becoming entrenched via those so-called second round effects through wages mentioned earlier.
8) How could investors position for the year ahead?
The good news is that the earnings underlying equity markets are typically a good hedge against inflation. US and UK companies still delivered profit growth over and above the rate of inflation during the 1970s and 1980s. But it is really important to look to individual companies whose business models are more resilient to greater inflation.
