The Return of Inflation – A Lesson From History…Perhaps?

As a financial planner, I help clients in many ways, often using cashflow modelling to provide bespoke pictorial predictions of someone’s financial future to help them work towards their objectives. One metric that I build into the system is Inflation. For years it is has tended to go quite unnoticed with an equivalent annual rate for Consumer Prices Index (CPI), over the past 7 years of about 1.4% p.a. and even over 20 years its only averaged  about 2.07% p.a.

I have been hearing several investment fund managers and economists give their predictions for 2021 in recent weeks and there are several common themes. One of them is ‘the anticipated increase to the rate of inflation’. So what drives inflation? Well on a basic level it’s the relationship between demand for goods and the supply of those goods. If the demand outweighs the supply, then this will push up prices. There is a widely accepted view that inflation will go up in 2021, but there is some difference in opinion as to whether it is short lived or the start of a longer increasing trend of rising inflation and something we have to be very careful about. What will happen in reality, will depend partly on what happens post global pandemic and also government policy.

  • Those that are predicting higher inflation for longer see the following happening:

As the extent of vaccinations increase, so will confidence. As a result, people will spend more, items will be ordered, holidays booked, money spent that hasn’t been in the last 12 months and demand will increase significantly. However, if supply chains are damaged, particularly in terms of manufacturing because of COVID and also potential Brexit issues in the UK, then it will not keep up with demand and prices, will increase.  

  • Those that are predicting inflation in the short term then a reduction back to current levels in a year or two, see the following happening:

There will be some increased demand, but nothing significant. People will be quite slow and sensible in spending money. There will be no issue in terms of supply and any increase to inflation will be short lived.

A problem with inflation is that once it gets in the system, it can be difficult to remove it. As prices increase, so will a demand for wage increases, which then means increased overheads for businesses, which then get past on to the consumer through, you’ve guessed it, price increases.  As for Government intervention, is there a lesson from the past? Who thought I was going to mention flared trousers and double-digit inflation in the 1970’s? Actually no, there is a correlation between now and the US in the 1960’s.

The decade started with low Inflation, averaging at 1.14% p.a. in the first few years of the Kennedy administration. They followed a policy of stimulating economic growth partly through tax cuts, reducing unemployment and following a plan to do so within parameters to limit inflation, partly by limiting wage increases. The Federal Reserve had a policy of low interest rates.  By 1965 Lyndon (not Boris!) Johnson was in charge and inflation started to creep up, which was not popular for those on fixed incomes and the elderly. Higher inflation discouraged people from saving money at a time of very low interest rates which put pressure on the dollar. COVID 19 was not around in the 60’s, but the Vietnam conflict was and the financial demands were significant on the US economy. Johnson did not want to ask Congress to pass a bill to raise taxes, as to do so would acknowledge the financial impact of the Vietnam War, so instead they borrowed it from the federal budget. By 1966, the government wage and price controls were breaking down, interest rates were up and Johnson had no choice but to lift personal and business taxes significantly. Both the US failures in Vietnam, and the problem with inflation was a major factor in the breakdown of the Johnson Administration. Inflation remained an issue through the decade that followed.

Author: Phil James, Grosvenor Consultancy Ltd

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