Inflation is here – and shifting politics means it's here to stay

Inflation is no longer a fringe concern.

It’s now something that even serious mainstream commentators – you know, the sorts given to harrumphing dismissively when anyone suggests that the authorities might not know what they are doing – are taking seriously.

The main question for investors now is – what will the world’s central banks do about it? And what does that mean for your money?

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Inflation is always and everywhere a political phenomenon

The FT’s Martin Wolf points out that today’s biggest inflationary risk stems not from the economic situation as such (referring to the fact that you can quibble all day about short-term unemployment figures and base effects and the rest of it), but from the change in political direction.

As if to confirm his point, Janet Yellen – the former boss of the US Federal Reserve, and now US Treasury Secretary (ie, America’s Rishi Sunak) – put out an interesting Twitter thread earlier this week.

It began: “Anyone observing the United States in recent years would see striking contrasts across our economic landscape. It is understandable that many Americans feel left behind. More and more are expressing their discontent. They are right to do so.”

That’s a pretty powerful mission statement, even in just that one tweet. And it goes on. Yellen notes that while the US has become ever wealthier, “a rising share of that income has gone to profits and disproportionate wage gains at the top, while middle-class families have faced wage stagnation.”

She’s not wrong. The share of income going to capital rather than to labour has been steadily rising in the last few decades. That’s at least partly at the heart of growing discontent.

What’s the answer? Well, some of us would argue that the Fed and other central banks haven’t really helped here, by inflating asset prices – and house prices in particular. But that’s not going to get much traction with the likes of Yellen, so let’s park that for another day.

Instead, her view is that we need to change our “framing of US fiscal policy”. In short (and this is me summarising, not using Yellen’s words), we need to ditch the low tax, small-government mantra, and instead trust the state to use public money to “invest” in infrastructure and ask corporations to pay their “fair share”.

It was a very strong indication that times have changed. Ronald Reagan once said that “The nine most terrifying words in the English language are ‘I’m from the government, and I’m here to help’” (it seems he didn’t coin the phrase, but he certainly popularised it). Yellen, needless to say, disagrees.

You can agree or disagree with any of this. My own view is that there’s a lot of truth in what Yellen says about the middle class being left behind. But you’ll hear exactly the same point made by plenty of people who are well to the right of Yellen – I mean, it’s basically the same argument that Donald Trump was making. It’s one thing to spot a problem; it’s quite another to come up with solutions to it.

Anyway, the solution for Yellen is “more government”. Which means “more public spending”. If you think all of that extra spending is going to come purely from raising corporation taxes, then you have a more optimistic calculator than me.

The central bank’s new job – and this goes for the UK as well, as none other than Keynes’ biographer Robert Skidelsky noted in an interesting piece for Project Syndicate earlier this week – is to work with the government to fund public spending. That means keeping borrowing affordable. That in turn, means keeping “real” (after inflation) interest rates low.

The unenviable juggling act facing central banks

What does that mean? It means that central banks face a really tough juggling act. They have to keep interest rates down – and not just the short-term ones which they control directly. They also need to keep long-term interest rates – bond yields, in other words – down too.

In a world where no one was worried about inflation, that wasn’t so hard. Rates kept falling all by themselves. That’s why we ended up with lots of negative-yielding government debt.

But today, markets are getting jittery. They are pushing bond yields higher. And if the central bank just ignores inflation, the risk is that bond yields keep going higher anyway (because you don’t want to own fixed-income assets when inflation is going up – or at least, you want to buy them a lot cheaper than they are today).

In other words, the Fed has to keep rates low and monetary policy stimulative (who else is going to buy all that government debt?). But it also needs to persuade markets that it will still take inflation seriously if it looks as though it’s going to get out of hand.

But it also can’t be too aggressive on that front, because markets are also rather overvalued (especially in the US) and any talk of raising interest rates might make them crash.

What a headache. How do they square this circle? I mean, they certainly have to keep “jawboning” – that is, talking as though they are at least keeping an eye on inflation. But we had an illustration of just how sensitive the market is to such talk from the release yesterday of the Fed’s latest meeting minutes.

This anodyne line in the depths of the conversation was enough to spark a mild dip in stocks when investors caught up to reading it. “A number of participants suggested that if the economy continued to make rapid progress toward the committee’s goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases.”

That is a very hedged quote. A few people on the Fed rate-setting panel said that if the economy keeps recovering as quickly as it has, then maybe – just maybe – they should start thinking about pencilling in a bit of time at some point to discuss whether printing money was still really a great idea.

Talk about hedging your bets! Yet even the hint of it caused a minor wibble in stocks.

The next big Fed meeting is in mid-June. For now I would expect Jerome Powell to keep talking inflation down. There will be talk of employment targets and inflation having undershot for a long time and the need for clarity once the distortion of re-opening is fully in flow, and all the rest of it.

But push is going to come to shove. And politics, not the monetary consensus of the 1990s, will be the driving force. So if markets try to force rates up, then the Fed will have to be more decisive. That’s when the full force of financial repression kicks in (for more on that, our Christmas podcast with Russell Napier is still as relevant as ever).

Markets are going to struggle to get used to that, which won’t be helped by the fact that, as Wolf notes, “one would have to be at least 60 years old to have experienced high inflation... as an adult”.

So I’d expect a bumpy ride for most things as a result (that includes gold, which is the thing I still see as the best hedge against all this).

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