When inflation gets weird

Once inflation is embedded in an economy, it gets much harder for central banks to dislodge it

Central banks have admitted that they can no longer describe inflation as “transitory” with a straight face. But they still seem to be confident that they can tackle it without too much trouble. A new paper from Vincent Deluard, analyst at US financial services group StoneX, titled Inflation is inflationary, suggests it’s not as simple as that.

First, Deluard looks at US consumer price index data going back to 1871, a period during which inflation averaged 2.2% a year. Overall, he finds that inflation follows a “random walk” pattern. In other words, you cannot reliably predict its future path by extrapolating from today’s data. 

However, once inflation goes above 7%, “things get weird”. First, inflation becomes “a lot less stable when it is elevated”. Second, “high prices beget higher prices”. The data no longer follows a random walk. Instead, once inflation is high, “the best forecast is that inflation will keep rising”. 

Rising prices change behaviour

Deluard confirms this is the case globally by using World Bank data going back to 1960. He finds that inflation has spiked above 7%, after five years of price stability, on 352 occasions. How easy is it to tackle once it gets to these levels? The answer is: “not very”. Inflation averaged less than 3% for each of the subsequent five years in only 12% of cases. At the other end of the scale, in 33% of cases, inflation went on to average more than 10% for the next five years. So faith that central banks can return inflation to “normal” levels – or at least, do so without causing a lot of pain in the process – appears to be misplaced. 

These findings make intuitive sense. When prices are stable or rising at a barely noticeable rate, everything ticks along smoothly. But once prices start rising at a noticeable rate, it has an impact on the behaviour of people and companies. “Consumers front-run their purchases to avoid paying more later. Creditors bill their clients faster. Workers bargain for pre-emptive wage increases.” In short, the velocity of money – the rate at which it is changing hands – shoots up. 

What does this imply for investors? If you haven’t done so already, it makes sense to prepare for more persistent inflation, just in case. Gold is one useful inflation hedge which we’ve always recommended you hold. On the equities side, higher inflation implies that the current rotation from “growth” to “value” – perhaps best demonstrated by the FTSE 100’s outperformance of the Nasdaq this year – is likely to continue. As James Ferguson of MacroStrategy Partnership notes, “value stocks... have good inflation-fighting credentials, outperforming growth during the inflationary 1970s and 1980s”.

Recommended

China’s economy is heading for a sharp slowdown
Chinese economy

China’s economy is heading for a sharp slowdown

With a slowing property market, Covid lockdowns sapping growth and the CSI 300 stock index down by 22% this year, China’s economy is in trouble.
6 Oct 2022
5 of the world's best stocks
Share tips

5 of the world's best stocks

Concentrating on a few highly profitable companies that excel in their fields can reduce the overall risk in your portfolio, says Rupert Hargreaves. H…
6 Oct 2022
The dangers of derivatives as the “Goldilocks era” ends
Investment strategy

The dangers of derivatives as the “Goldilocks era” ends

That this is no longer a benign environment for investors, says Andrew Van Sickle. But – as the recent pension-fund derivatives blow-up shows – not ev…
6 Oct 2022
There’s still time to submit your energy meter reading to avoid a higher charge
Personal finance

There’s still time to submit your energy meter reading to avoid a higher charge

You need to submit your gas and electricity readings as soon as possible to avoid overpaying after the October energy price increase.
6 Oct 2022

Most Popular

Should you take a 25% tax-free pension lump sum in instalments?
Pensions

Should you take a 25% tax-free pension lump sum in instalments?

Taking out a 25% tax-free lump sum sounds appealing but it might not be the best way to manage your pension
30 Sep 2022
Markets may have bounced, but this is not the end of the bear market
Stockmarkets

Markets may have bounced, but this is not the end of the bear market

Stocks are back on the rise, commodities and precious metals prices are up – even the pound has rebounded. But none of this is typical of bull markets…
5 Oct 2022
October’s Premium Bonds: how to check if you are a winner
Savings

October’s Premium Bonds: how to check if you are a winner

NS&I has added almost 110,000 more prizes to October’s Premium Bond draw – are you a winner?
4 Oct 2022