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Are we facing a new era of inflation?

Since the last few months of 2021, we’ve witnessed a sharp increase in inflation. The Consumer Prices Index rose by 9% in the year to April 2022, up from 7% in March. The Bank of England expects inflation to surpass 10% before the year is over. 

These kinds of levels haven’t been seen since the early 1980s, with relative price stability enjoyed for the last 40 years. So, let’s go back and look at the conditions that led to relative price stability – generally, it has been attributed to the absence of any serious imbalances in the labour and goods markets. 

After a relatively choppy decade in the 1980s, inflation was brought under control in the UK after the early 90s. In the late 90s and early 2000s, the first signs of a deflationary trend began to emerge, but this was brought to an abrupt end in 2008 when the financial collapse pushed inflation back over the 2% long-term target. 

The 2008 financial crisis began in the United States but quickly spread to Europe. Unemployment became rife and Central Banks resorted to measures like quantitative easing and forward guidance. To varying degrees, this allowed Central Banks to manage some of the volatility in the markets. Despite issues like Brexit causing uncertainty on a national level in recent years, the international economy in the years before Covid-19 was fairly balanced, particularly with regards to inflation. 

One significant factor in keeping inflation at bay was technology. This is because it has become more and more affordable as the decades have rolled on. Just contrast how expensive computing equipment was at the beginning of its emergence to how affordable it can be today. It has also made certain services more affordable relative to their offline counterparts. Technology has, for some time, had a deflationary impact. 

The pandemic ushered in a new era

One factor that changed the course of the economy in many significant ways is the pandemic. Firstly, the severe initial restrictions slowed the economy, with many sectors grinding to a halt, before a razor sharp recovery when society reopened. 

This uptick came after the government had flooded the economy with cash in the form of furlough payments and subsidies, an unprecedented level of financial support to keep things ticking over in a time of dire crisis. Many families took the opportunity to save during lockdown and, as a result, have been ready to spend as we return to normality. The crisis in Ukraine is another major contributing factor, with energy and food prices soaring. 

All of this brings us to where we are today. Inflation continues to grow and it may be many months before we see it begin to settle down. It’s no real surprise, then, that the Bank of England is considering further interest rate hikes in an effort to curb the rise in prices. 

So, why is inflation on the rise?

  1. The rapid reopening of economic activities after Covid-19
  2. The rise in energy prices caused, in part, by war in Ukraine
  3. The impact of what statisticians call the “base effect”

The winners and losers of high inflation

As with every economic development, there are winners and there are losers. So, who does high inflation benefit? Well, debtors will see their debts devalued. Investment bankers benefit too, given that a large part of a banks’ income is derived from the different between passive and lending rates. The higher interest rates create the conditions for higher spreads and, consequently, greater profits. 

The real losers in a period of high inflation are families and consumers, who see their purchasing power slashed due to ever-increasing prices. In fact, price stability is considered one of the fundamental conditions for increasing economic activity and employment. High inflation, like what we’re experiencing now, damaged both consumers and the economy. Wages become a problem, too. If wage increases aren’t anchored to inflation (most aren’t) then, without significant pay rises, the real value of wages decreases over time in periods of high inflation. 

A look to the past: crisis and strategy

It can be instructive in times of crisis to look to the past for wisdom. One of the earliest examples of recorded inflation is the price revolution that took place in Europe between 1500 and 1700. During that period, prices increases drastically in Europe thanks to the influx of precious metals (gold and silver) from the recently discoverd Americas, along with a general increase in the population. 

This led to an increase in the demand for goods, which led to rising prices. On this occasion, the most affected group were the workers, since wages did not substantially adjust and purchasing power was lost. Landowners also lost out because the value of the rent they received from peasants went down. 

This price revolution was then followed by other cases of inflation, for example in France during the Revolution. Perhaps the most famous case of inflation in Europe occurred in Germany after the First World War. During the war, inflation was already growing in Germany thanks to the tremendous costs associated with the war. Germany printed money with the intention of forcing their newly conquered neighbours to pay their debts upon victory. This did not happen and Germany was made to pay enormous reparations, transfer industrial plants to France and the UK and sell territories in which there were enormous coal and iron deposits. To put the level of hyperinflation into perspective, Germans were burning money to keep warm because it was cheaper than coal. 

The final example we’ll look at here comes from the UK in the 1970s. Famously, the decade saw spiralling inflation, caused primarily by a tripling of fuel prices and rapidly rising wages. By the end of the crisis, the Bank of England had raised its base rate to a huge 17% in an effort to combat the skyrocketing prices. 

Looking ahead

The period we’re in now is difficult. For investors, it can mean poor performance and uncomfortably high volatility in portfolios. There are a few age-old tactics any investor can use to navigate periods of disconcerting volatility calmly: 

Firstly, avoid making any knee-jerk decisions. One of the biggest mistakes investors can make in difficult periods is to panic and disinvest completely. In our experience, this usually serves to crystallise losses and can mean missing out on the recovery.

Secondly, don’t try to time the market. Everyone wants to buy at the bottom and sell at the top, but this is not the goal of long-term investing. Timing the market is notoriously difficult – you essentially have to be right twice.

Finally, put the volatility in context. Ups and downs are a fundamental part of investing. The volatility we’re seeing today is the latest in a long list of rocky patches. The market moves in cycles and, historically, has a clear growth trend: this means that the positive periods that follow are more prolonged than the negative ones.

Ultimately, it’s about sticking to the long-term plan. Periods of poor performance and high inflation happen, but they also come to an end. Spiralling inflation in the 1970s was eventually brought under control, and Central Banks are acting to bring down the current price increases. Slow and steady wins the race here.

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