The writer is chief market strategist for Europe, Middle East and Africa at JPMorgan Asset Management
Are we headed back to the economic chaos of the 1970s? With soaring commodity prices and the prospect of very high, if not double-digit inflation, you can see why investors are nervous.
Economists, including those at central banks, have been offering reassurance. Testifying to the UK Treasury select committee in November last year, the governor of the Bank of England Andrew Bailey said: “We are a very long way away from the 1970s.”
The economic community points to two structural changes that have happened in the UK economy. The first is the de-unionisation of the labour market. Back in the 1970s, when headline inflation spiked, unions pushed for higher pay under the threat of strike action. The increase in inflation due to oil prices fed quickly into higher wages. Companies’ costs rose further, forcing them to raise prices yet again.
At that time, the government set interest rates but, unsurprisingly, was very reluctant to tighten policy amid rampant inflation and widespread public discontent. Very large rises in interest rates, and very deep recessions, were required to break the wage-price spiral.
The second structural change relates to central bank independence and clear legislated inflation targets, which should prevent a wage-price spiral taking off. Workers, it is said, will know that if they start asking for higher pay, inflation will rise further and then so will interest rates and mortgage payments. So companies won’t raise prices, and workers won’t ask for more pay. And, if they do, the BoE will act.
While I appreciate the theory, I can’t help wondering how this will work in practice.
Let’s take the labour market. In the late 1970s, about 50 per cent of UK workers were in a union. That number is now 24 per cent. The largest union is Unison, which covers the NHS. Is it really tenable for the chancellor to provide 3 per cent pay growth for the health service this year now we are staring at 8-10 per cent inflation?
I also think that workers not in unions will prove just as pushy in asking for higher pay. This labour market is incredibly tight. Vacancies are at a record high. If workers, not in unions, feel confident that there isn’t a potential candidate ready and willing to replace them, they will ask for more money. We are already seeing this. In January, inflation was 5.5 per cent while pay growth was 6.3 per cent year on year.
In November, the BoE’s Monetary Policy Committee stated: “Talk of a wage-price spiral is just completely wrong.” I’m not so sure. But surely we can rely on the second structural change — the independence of the BoE? It will step in early and decisively to cool the economy and prevent inflation becoming embedded.
I don’t doubt the institution’s integrity but I also don’t envy the task ahead for the MPC. Just look, for example, at the criticism the governor recently experienced after explaining his hope for modest pay growth to prevent inflation taking over. Raising mortgage rates, alongside soaring utility bills, will not make the committee popular.
The BoE will also be aware of how dependent the chancellor’s finances are on its decision. The vast quantity of government bonds the bank bought during the pandemic leaves the Treasury’s cash flows very sensitive to changes in the base rate. The BoE rebates profits from the gap between the coupon payments received on these bonds and what interest rate it pays to commercial banks that hold money at the central bank. As the benchmark rate rises, that profit rebate shrinks. Given Rishi Sunak will also be under pressure to spend more and support household incomes in the face of rising inflation, this would add to his worries.
To be clear, it is not my base case that we are headed back to the 1970s. By my calculations, which are changing rapidly given commodity price moves, inflation may rise above 9 per cent and be persistent at that level for much of the year, before slowly falling towards 3 per cent through 2023.
But, unlike some, neither am I dismissing a much more adverse scenario. We should remember that in the decade before the 1970s it also looked as if inflation was structurally under control, roughly steady at 2.5 per cent. This led to complacency in economics and policymaking, which arguably sowed the seeds for the economic chaos of the 1970s.
As investors, the clearest implication is that we face years of deeply negative real interest rates. And while government bonds may have cushioned portfolios in light of the current the risk-off environment, we should question their role as an all-weather “riskless” asset.
Source: Economy - ft.com
