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”.

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