It’s time to worry about inflation

Andy Haldane is something of a Bank of England lifer. He’s retiring this week from his position as chief economist, but he’s been working at the central bank for more than 30 years. Next he will take up a position as chief executive of the Royal Society for Arts, Manufactures and Commerce (RSA). Some of you will, I know, immediately think of his pension: imagine being about to receive 30 years’ built-up defined-benefit pension payouts. What joy.

But there’s a lot more to Haldane than a happy semi-retirement. He’s not just been a Bank of England lifer. He’s also been something of a Bank of England maverick. He’s been hugely critical of the financial sector, outspoken on bankers’ pay, forward thinking (not always in a way MoneyWeek readers would approve of) on the death of cash and certainly not shy when it comes to his opinions on all matters economic.

Last year, when much of the rest of his profession had gone, as he put it, “Chicken Licken” on the economy, he was telling them to stop “catastrophising” and start looking forward to a stunner of a recovery. We agreed with him on this (Haldane and I have some history of disagreeing, so this has been interesting).

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Now he’s telling them the recovery has been so stunning that they might want to worry a little about inflation: last week he was the only member of the Bank’s Monetary Policy Committee (MPC) to vote to tighten policy (oddly, we were with him on this too). So when we meet (on Zoom, sigh), this mix of optimism and mild anxiety is the first thing I ask him about.

The economy has made up the lost ground

How is the recovery going and how much do we worry about inflation? The economy is going “great guns”, he says. No wonder. The collapse was caused by the lockdown restrictions, so their removal would naturally produce an “atypically sharp bounce-back in activity and demand. And that is exactly what is happening. If anything, [it] is running ahead of everyone’s expectations. We see it on the high street [and] in the pubs and restaurants. We even see it in the GDP data”.

Thanks to this “really very punchy recovery” we have made up “all of the GDP ground lost from last year” – and that’s before we have even finished reopening. Will it carry on? Is he perhaps worried about the supply side of all this? The demand recovery makes sense. Most people have had their lost incomes replaced, so when they are allowed to spend they do. But the supply side is not so intact: there appear to be bottlenecks all over the place in the global supply chain.

Ever the optimist, Haldane thinks we should see this more as a “sign of success” than anything else. Sure there are some problems with, say, chip shortages and hospitality staff, but this is all about businesses and workers finding their feet. The problem is not so much the short-term shortages, but the “potentially adverse implications for price pressures” they might cause – and the worry that these may not be short-term.

This isn’t just about Covid-19 itself. The reaction to the pandemic has exacerbated some pre-existing trends. The first is globalisation. Even pre-Covid-19 we were seeing some “fraying, or in some cases retreat” in the ability of goods, services and people to move freely across borders. Brexit added to that and Covid-19 became an “additional amplifier”. Countries may now want to react to the fracturing of international supply chains during the pandemic by working to “build greater resilience into their domestic supply chains”.

Did EU migrants depress British wages?

The other trend to keep an eye on here is “changing patterns of flows of people”, in particular a slowing in the number of EU migrants coming to work in the UK. Add these up and the years of cheap labour and cheap goods may be over – as is their disinflationary effect. Will we see this in wages first, I ask? Pre-Brexit we were told (over and over again) that the millions of migrants did not affect wages on the downside (in other words, the rising supply of labour had no impact on the price of labour). But now, as fewer people come, we are told that this trend bolsters wages (the falling supply of labour does affect the price). So which is it?

Both, says Haldane. You can argue that migrant labour did not produce a “whopper impact on aggregate pay rates across the UK” for the simple reason that “migrant labour adds to both the demand and the supply side of the economy and is therefore a bit of a wash in terms of net excess demand”. But it is the case that in “certain sectors and in certain parts of the wage distribution, particularly the lower end... there were some signs of effects of migrant labour”.

I get the idea: it was the lower-paid who suffered from rising supply of labour. Good news then, perhaps, that it is also the lower-paid who are reaping the rewards of the lower labour supply: it is in hospitality and retail where wages are now rising the fastest. This could be transitory, says Haldane – perhaps as pay picks up and furlough ends, people will re-enter the workforce and we will be back to square one. But there is also a reasonable chance that we see a “mini-game of leapfrog between rates of inflation and rates of pay”. If so we will see, as we did in the 1970s and 1980s, “persistence in price pressures” beyond the immediate opening up of “bottleneck effects”.

Persistence to how high a level? The Consumer Price Index (CPI) numbers for May suggest that annual inflation in the UK is running at 2.1%. Haldane would not be surprised to see “a big figure three during the course of this year”. That might reflect energy prices feeding through into petrol and the like (oil prices were extremely low last year). But it might also reflect the “start of a slightly more persistent trend upwards”. Speak to any business and you will find them saying that all inputs are rising in price. “Not just petrol and diesel and gas, but bricks and concrete and cement and plasterboard and chips. And that’s before you get... to things such as houses and equities and bonds.”

Most of these price pressures have not yet popped up in consumer prices, so the “big question” is whether and when they will. Will businesses have to take the hit, or do they have the pricing pressure to pass them on to consumers? “Others of my central banking colleagues and brethren think those effects will be fleeting; I am of the view they could stick around for a bit longer... And therefore we could be looking at a breach of our 2% inflation target for a somewhat lengthier period than we are currently factoring [in].”

On Haldane’s “balance of probability” price pressures will build rather than abate into next year. Interesting (and scary). But if he thinks that “there’s a risk and indeed a rising risk” that 3% won’t be the peak, what makes him so sure that this won’t turn into a 1970s wage-price spiral? “The Bank of England.” When Haldane joined the Bank in 1989 “the best single predictor of interest-rate changes... wasn’t the path of GDP or inflation. It was whether Mrs Thatcher had lost a by-election. So it was all about the politics then”. Now the Bank is independent and works towards a “clear target” for inflation (2%).

An independent central bank is crucial

So while he worries that the target might be “persistently missed” over the next year as the rest of the MPC takes the view that the uptick in prices will be transitory, he has “huge amounts of faith” that it “will do the right thing” long before we get to anywhere near scary double-digit inflation. So should we worry about rising interest rates then? Right now the market is barely pricing in rate rises at all. But if Haldane is right on both inflation and the integrity of the inflation target, they will have to rise faster than most expect.

Haldane agrees. We are “a world away” from anything that anyone who experienced the 1970s and 1980s would consider tightening. “Incredibly low” rates globally will be with us for some time. That said, anything sharper than expected is going to come as a surprise as “the majority of people with mortgages these days haven’t really experienced a rate rise”. And that could magnify their impact. What might that do to house prices I wonder? After all, it’s a matter of scale. A rise in rates from 0.1% to 1% might sound small , but it is still a tenfold rise in interest rates. Haldane is not worried. First, thanks to the rise in popularity of fixed-rate mortgages (you’d be mad not to have one at the moment), people are “immunised” from rising rates in a way they never have been in the past. Even those now rolling off old ones onto new ones will be seeing unchanged or even lower rates than five years ago, “such has been the compression in mortgage spreads over that period”. What’s more, he reckons there are “pretty potent... forces acting on housing demand”. Pandemic savings (the “savings lake”) are translating into deposits at the same time as “attitudes towards housing are changing in the light of working from home”. That has created a supply-demand imbalance, which is why house prices are rising so fast (13.4% annualised on Nationwide numbers) – and possibly why they won’t be affected by a small rise in interest rates.

Would he buy a house now, at these prices, I ask? He dodges that one neatly: “Can’t afford to Merryn, I’m moving to the charity sector”. Instead I wonder if he’d buy bitcoin. You can listen to our discussion on this on the podcast, but I can summarise it for you in two words: probably not.

What about equities? This isn’t his area, but he notes there have been three uncertainties affecting markets over the last 18 months: Covid-19, the resilience of the financial system and Brexit. The uncertainties around the latter haven’t fully disappeared but they have dissipated. Virus uncertainty is (finally) going the same way. And the resilience of the financial system is no longer really in doubt either: “through the Covid-19 crisis, our financial system has stood tall”. That all implies that risk premiums should be falling: “I think you can make a… good case on fundamental grounds for the valuations... across UK markets”. In this there is, as regular readers will know, something else MoneyWeek and Haldane can agree on. Strange times.