Editor's letter

Things won't just return to normal – that's not how inflation works

You might think that, if inflation is indeed “transitory”, we just need to wait and everything will return to “normal”. But this is a grave misunderstanding of how inflation works, says John Stepek.

Inflation is still the biggest topic in investment. To get an idea of what’s going on and where we might be going, let’s consider a stylised picture of the economy over the past two years or so. In 2020, coronavirus triggered a lockdown that stopped people from going out for a prolonged period. But governments stepped in to pay workers who would otherwise have lost their jobs. So consumers maintained their pre-pandemic buying power, but could only spend their money on “indoor” goods and services, such as exercise bikes and Netflix subscriptions. Demand for these spiked.

You might think the beneficiaries of this surge would have recognised it as temporary. But it seems not. Many appear to have either assumed the extra demand was permanent, or favoured a strategy of stocking up just in case. As a result, some companies now have too much inventory, or have been surprised when demand this year has fallen short of forecasts, and some may also have hired too many staff. But just as the “staying in” sector over-ordered based on a temporary surge in demand, so the “going out” sector has underinvested based on a total collapse in demand. That’s the fundamental reason for airport chaos right now, for example.

The question now is: what happens next? You might think that the implication here is that inflation is indeed “transitory” – we just need to wait for the pig to pass through the python, as it were, and everything will return to “normal”. But this is a grave misunderstanding of how inflation works, according to none other than the Bank for International Settlements (BIS), often described as the central bankers’ central bank.

When inflation starts to feed on itself

In a recent paper, the BIS argues that there are “two basic inflation regimes – ‘low’ and ‘high’”, notes Dario Perkins of TS Lombard. During a “low” inflation regime, spikes in specific sectors will indeed be transitory – rising prices lead to higher supply and prices come back down. But once you move into a “high” inflation regime, things change, “with inflation itself becoming the focal point for private-sector decisions”. In other words, inflation becomes a problem when it starts to change our behaviour.

It’s very clear that this is already happening. Unionisation may not be as extensive in the UK as it was in the 1970s, but we’re starting to see more and more strike action nevertheless – dockers in Liverpool are voting on action now after rejecting a 7% pay rise as “inadequate” (which, given that inflation in June came in at 11.8%, is perhaps understandable). Royal Mail’s workers have also voted to strike, while BT’s staff are going on strike at the end of the month. In short, the inflation genie is well and truly out of the bottle.

So what can you do about it? Rupert Hargreaves looks at a selection of real estate investment trusts (Reits). Property is traditionally viewed as an inflation hedge (although it’s a bit more complicated than that), but perhaps more importantly, Reits represent a handy source of dividend income. Meanwhile, Cris Shotlo Heaton looks at a very intriguing play on cheap South Korean stocks. Finally, don’t forget that inflation also means you need to be more proactive with your personal finances – Ruth Jackson-Kirby considers what rising interest rates mean for your mortgage and your savings.

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