Are we getting too complacent about inflation?

All the talk at the moment is of deflation. But, asks John Stepek, what if the thing we should really be worrying about is the return of inflation?


Mark Carney: the Bank of England seems in no rush to raise interest rates

Deflation is the big topic of the moment, with UK prices falling for the first time since the 1960s.

I covered it in Money Morning earlier this week. No one is really worried about us turning into Japan. Everyone is saying we should just kick back and enjoy this phase of low prices.

But what if the thing we should really be worrying about is a return of inflation?

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The British jobs picture is improving fast

Consumers have more money. More people have jobs. Companies are clearly expanding, or they wouldn't be hiring.

Sure, Britain has plenty of underlying structural problems mostly stemming from a distorted property market and if you could start the economy up from scratch, you wouldn't start here.

But accepting all that, even the most bearish commentator would have to agree that if you had landed here from another time or another planet, the last thing you'd expect to see would be interest rates at their lowest levels on record.

Yet the Bank of England seems in no rush to raiserates. The most recent inflation report, released earlier this month, suggests that inflation won't return to the 2%-ish mark until near the end of this year. And interest rates aren't likely to start rising until the middle of 2016.

That's quite something. Last year, lots of people suggested the Bank might have to raise rates before the election, or very rapidly afterwards. But now we're looking at a whole year before anything moves at all.

Isn't there a chance that we are getting a bit complacent here? As Dr Peter Warburton of Halkin Services points out, "the Bank has the habit of upgrading the supply potential of the economy so as to leave the margin of supposed slack constant."

We're talking here about the output gap'. This is another of those semi-mythological beasts that economists are fond of. Put simply, the output gap tries to measure how much stuff' (people and equipment) is just lying around not being used to its full capacity.

If there's loads of spare stuff' lying around, then it should be possible for the economy to grow without sparking inflation. You can just bring the spare stuff back into action, before you have to worry about there being any impact on inflation.

But it's notoriously hard to measure. As such, it's one of those statistics that you can really adapt to whatever story you want to tell.

And given the forecasting record of the Bank (and pretty much every other professional forecaster), you can't really take its views as much of a guide to the future.

The consensus is comfortable and usually wrong

We'll have just enough to keep the economy ticking over, but not too much to cause any trouble. Conveniently enough, that's the golden scenario for anyone trying to sell you any sort of equity-based investment, and while it wouldn't be ideal for bonds, they could just about cope with it too.

That seems rather too optimistic to me. Either we're growing strongly and the economy doesn't need these sorts of emergency interest rates, or we're heading for a major stumble and these rates are just the beginning, and we'll see more quantitative easing. Bouncing along the happy medium feels more like walking a tightrope.

If you look at the global situation, plenty of things point to more wage pressure. Minimum wages are rising in the US (see my colleague Matthew's piece on this for more details). There's pressure on the workforce in Japan, increasingly the UK, and the US. Something's got to give at some point.

As Warburton puts it: "One day soon, this roaring labour market will shake up the complacent consensus regarding the timing of that first Bank hike". Then we might see just how well financial markets cope with the shock.

We'll have more on inflation in the next issue of MoneyWeek magazine. This debate will also be one of the biggest discussion points at the MoneyWeek conference on 12 June book your ticket now if you haven't already.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.