Why we should stop worrying about inflation

All this suggests a classic case of a transitory, rather than a permanent, increase of inflation

It is in the nature of conservatives to worry about inflation. It is usually caused by monetary policy that is too loose or a fiscal policy that is too profligate, neither of which sit well on a conservative’s mind. Further, inflation tends to punish savers and help debtors, which cuts against the sort of society a conservative instinctively prefers.

Therefore, it is hardly surprising that conservatives should respond to reports of a post-pandemic inflation spike by furrowing their brows, whistling inward and sucking their teeth. However, we in the UK should not worry about inflation – at least not yet.

First, much of the data is hidden by noise because of the low base and extraordinary circumstances of last year. One of the main drivers of the current increase of inflation is commodity prices (oil, steel, wheat, gold, aluminium, fertilisers, semiconductors, pork bellies and the like – think Trading Places). Yet both on the demand side and the supply side, 2020 disrupted normal affairs. For instance, precious metal mines in South Africa produced far less than normal, while steel mills around the world were shuttered for long periods. For a year, the world has simply produced fewer raw materials and manufactured goods, and has been much less able to get them to market, than would have been the case without the pandemic restrictions.

Meantime, on the demand side, people could not buy cars, developers could not build houses, consumers stopped buying jewellery and clothes, and states brought infrastructure projects to a halt. As all this unravels, we are bound to see some inflation (which is a year-on-year comparison), as everything catches up, and sectors strive to reach new supply-demand balances and equilibrium prices. After all, it is easier to start buying engagement rings again than it is to restart a gold mine. (As an aside, it is difficult to know what the Bank of England could, or should, do about rises in global oil and steel prices, which is why it tends to prefer core inflation, which strips out such items.)

Secondly, we are seeing the release of pent up consumer demand and accumulated savings. Furlough schemes during the pandemic meant that workers kept receiving income, but did not have much to spend it on, as shops were closed and they did not have to pay for transport to offices. These accumulated savings are combining with a reopening of consumer businesses to release a large quantity of money back into the economy. However, unless one imagines that savings and pent up consumer demand will last forever, this is by definition a temporary phenomenon.

Thirdly, inflation in the 1970s was in part due to the bargaining power of the unions. They were able to secure above-inflation wage increases (forcing businesses to raise prices) by threatening mass strikes. It is harder to imagine a similar process occurring in our de-unionised, de-industrialised gig-economy. Given inflation is by definition a wage-price spiral, without the wage part of the circle, price increases will inevitably run into demand side constraints at some point.

All this suggests a classic case of a transitory, rather than a permanent, increase of inflation – and indeed, there are small hints that commodity prices are coming under control. Partly, this might be because China – which has an outsized effect on global inflation due to their huge consumption of commodities – has started to release its strategic reserves of certain items, such as copper, in an effort to hold down prices. Perhaps it is also a sign that supply chain bottlenecks are clearing. We do not have much idea what will happen when the government’s furlough cheques stop, and its support of certain sectors ends. The pandemic, and the state’s response to it, were by definition unprecedented. It could well be that we are now in a moment of false security, the sunny weather before the economic hurricane so to speak. It could be that in six months, businesses start to go bust, people start losing their jobs, banks withdraw credit in response, demand craters, and thus more businesses start struggling. We simply do not know.

It is therefore worth considering the asymmetric risks of inflation and deflation. Central Banks, as we saw in the 1980s, know very well how to deal with inflation, given the determination to do so. However, Japan in the 1990s, and the southern states of the European Union in 2009, showed that dealing with deflation and lowflation are entirely different matters. Deflation is lethal for a capitalist economy. As deflationary expectations set in, people and businesses start holding off on spending, knowing that what they want to buy will be cheaper in future. Further, deflation raises the real value of debt, increasing the chances of cascading bankruptcies that only make deflation worse.

Deflation caused the Great Depression and, contrary to popular belief, deflation (not hyperinflation) precipitated the collapse of the Weimar Republic. Yet deflation remains a puzzle for policymakers: as the economist John Maynard Keynes had it, central banks and governments find themselves “pushing on string.”

It could be that over the next eighteen months inflation surges as a tsunami of household savings and banking sector excess reserves release into the economy and the velocity of money reclaims its pre-pandemic levels. However, given the unique economic moment in which we find ourselves, central banks may want to pause to take stock of the situation. They might be wise to see what comes next, rather than rushing in to take policy decisions. At least that is a sentiment conservatives would probably endorse.