Why do we have high inflation and can we do anything about it ?

The last six months have seen rapid rises in inflation followed by increases to the cost of borrowing and falls in valuations across all asset classes, equities and fixed interest. ?In the UK, the government that seems to be doing little to communicate on the bigger picture, leaving room for pundits, theorists and media noise .?Whilst researching and finding answers for anxious clients,?it has become apparent that I need to split my original intention for one article into three; looking at the current causes of inflation, asking how it effects our investments and pensions from a sustainability perspective and finally what actions or opportunities may be available. It is also apparent that it is a fine balancing act for central banks and policy makers as they face wrestling with inflation, interest rates, wage increases whilst also trying to prevent a recession.

Hello, my name is Jill, Director and Life Centred Financial Planner at Big Picture Financial Planning, working with clients to plan for their future, have the best life possible with the money that they have, align their investments with their values, manage risk and protect the ones they love.?

Six months into 2022 we are in the midst of an exceptionally rare economic backdrop.? (1)

Could we have seen this coming, in part maybe but the banks at the end of 2021 were in a wait and see mode and confident any inflationary pressures could be nipped in the bud with interest rate increases. In any case we couldn't predict the actions taken by policy makers. In the first of three articles,? I look at where the inflationary pressures have come from, the difference with demand-pull inflation and supply-push inflation, the role that an increase to interest rates may play in curbing demand led inflation whilst potentially triggering a recession and how this is all exacerbated by the invasion of Ukraine by Russia, the extent of which, blindsided everyone.

Inflation refers to the rate of increase in prices for goods and services over a given period of time. ?The graph below ( 2 ) shows the fluctuation in the annual rate of inflation,?as measured by the consumer price index, the change in price of a basket of goods and services over the last sixty years.

Source: https://www.macrotrends.net/countries/GBR/united-kingdom/inflation-rate-cpi

The years from 1993 to 2020 were a period of stable and low inflation rates that remained?well within the Bank of England’s target expectation of 2% per annum. ?There was a sharp decrease in the rate of inflation to 0.99% in 2020,?bought about by the societal lockdowns of the covid pandemic, a severe reduction in demand that outweighed any reductions in productivity plus the decline in oil prices to $21.48 per barrel in April 2020 compared to?$114.67 in May 2022. (3)

It is important to bear in mind, at this point,?that there are two types of inflation, demand driven inflation that pulls prices increases through and supply driven inflation that occurs through a scarcity,?that pushes price increase through.?

Demand-pull inflation has been gradually increasing, globally, since the autumn of 2021.?In the UK we had large scale financial and policy support during the pandemic and this helped to?maintain a plentiful money supply, so when lockdowns eased there was an unleashing of a pent up demand for goods and services, coupled with the means to pay for them.?This led to a sharp increase in demand led inflation.? A plentiful supply of money and an increase in demand can?can usually be catered for in economies by increasing supply.? However, couple a strong post pandemic demand with a post pandemic bottleneck in the ability to supply, there will be further upward pressure on prices.? Furthermore, whilst the economies of many countries opened up despite a rise in covid infections, China, the global manufacturing hub, reintroduced a zero tolerance towards covid infections and imposed further lockdowns in Shanghai and Beijing.?These have only been lifted as recently as 1st June this year. ( 4 )?We have some time to go until the global manufacturing hub with its supply chain bottlenecks and pent up demand find an equilibrium.?

One tested method of trying to achieve an equilibrium is to dampen demand driven inflation by reducing the money supply.?This can be done by central banks controlling interest rates.?By increasing interest rates and therefore the cost of borrowing, disposable income of homeowners is diverted towards mortgage payments and also discretionary spending becomes tighter.?For businesses the cost of borrowing can curtail any spending and plans to investment for growth.?

At the beginning of the year, despite the obvious post pandemic problems, central banks were confident that expectations for inflation would remain anchored i.e. remain close to their targets, and if necessary, could be gently nudged back down with small increases to interest rates.?On the 3rd February this year,?the Bank of England Monetary Committee increased the base rate by 0.25% to 0.5% , this has been followed by three further increases of 0.25% and now the base rate stands at 1.25%from the beginning of June.? ( 5 )

However we now need to add into the mix the fact that everyone was blindsided by the invasion of Ukraine by Russia, when Putin announced on the 22nd February 2022, that Russia recognised the two regions of Luhansk and Donetsk as separatist governments.?

This was swiftly followed by a series of economic sanctions imposed against Russia by the UK, the US and most of Europe, which also included an embargo on importing Russian oil and gas. However, with Russia being the leading supplier of natural gas in the world as well as accounting for 12% of the global oil supply, gas and oil suddenly became notably scarcer pushing up prices of remaining oil and gas.??( 6 )

As well as the horrific humanitarian consequences of war, the conflict in Ukraine has disrupted the growth of?wheat and barley for export, which will add to the scarcity supply push of price increases in certain essential foods and add to inflationary pressures. Ordinarily, when there is a scarcity of materials, goods or services, it can be possible to source alternatives or even by choice, to avoid altogether,?that which is scarce.?However, when scarcity occurs in essential materials, goods or services, it is very difficult for demand to reduce, the consequence therefore is we have two drivers of inflation working together,?demand led and supply led.? Then to make matters worse, as energy costs?are core to manufacturing and transport this pushes up the price of finished goods too.?

The rate of inflation was reported as 9.1% in May of this year,?( 5 ) we are now in the danger zone where inflation expectations have become unanchored. ?

The burden of increased costs for domestic energy, food and finished goods is being felt most by working people on a fixed incomes who are experiencing a loss of purchasing power of their labour and are now demanding pay increases form their employer’s to compensate.?This can lead to a wage and price spiral,?as the cost of labour can add further inflationary pressures, if it is not correlated with increase in productivity and once baked in, it can make the unwinding of hikes in inflation more difficult.??

Discretionary spending is already tightened by the increased energy costs for both people and businesses, so one wonders if there is any more merit in increasing interest rates, which could create more harm, reduce investment spending by businesses and lead to a recession.?Central banks warned that they are treading a fine line with increasing interest rates and staving off a reduced growth and a recession.? The stock market reacted with the fear and uncertainty over a recession, with falls in equity valuations?(company share prices), most notable was the drop on June 16th. ?Perhaps the banks are considering holding back on any further interest rate increases, we will have to see what the latest CPI figures are on 20th July and how the Bank of England reacts on 4th August.?

I wonder if this is why?the government is providing financial support to each and every household, to help with energy costs, rather than risk a wage price increase spiral.?

For now, using interest rates to tackle demand - pull inflation maybe the first point of call for central banks rather than trying to control cost push inflation which is more fraught due to the uncertainty surrounding the global supply chains and the difficulty navigating alternative energy and food sources.?Central banks and policy makers are faced with a challenging few months trying to wrestle with the interacting forces of global and domestic inflation, growth prospects for the economy and demands for wage increases.? ( Ghal 2022 )

There will be a follow up article to this looking at how this impacts on our investments, pensions and what financial planning opportunities or measures that can be taken.?

Sources :

1. Inflation & Interest Rate Dilemma : June 2022 Amar Ghal Blog Post https://ebi.co.uk/market-commentary/inflation-interest-rate-dilemma/ last accessed 9th July 2022.
2. UK Inflation Rate 1960 -2022 : Macro Trends https://www.macrotrends.net/countries/GBR/united-kingdom/inflation-rate-cpi last accessed 5th July 2022
3. Crude Oil Prices - 70year historical chart : Macro Trends https://www.macrotrends.net/1369/crude-oil-price-history-chart last accessed 5th July 2022
4. Some of Beijing of back to work, whilst Shanghai inches closer to ending covid lockdown: 30th May 2022 Reuters https://www.reuters.com/world/china/some-beijing-back-work-shanghai-inches-closer-ending-covid-lockdown-2022-05-30/
5. Interest Rates and Bank Rates : Bank of England https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate last accessed 5th July 2022
6. Russian oil industry - statistics & facts :?Statista https://www.statista.com/topics/5399/russian-oil-industry#topicHeader_wrapper?Last accessed July 2022?
7. Leading gas?exporting countries : Statista?https://www.statista.com/statistics/217856/leading-gas-exporters-worldwide/ last accessed July 2022

Jill Turner is Director of Big Picture Financial Planning, who offer independent financial advice as an appointed representative of Valid Path Ltd., who are regulated by the financial conduct authority.?Jill is a member of the Personal Finance Society, a chartered associate of the London Institute of Banking and Finance and a member of the UK Sustainable Investment and Finance Association and currently serves on their policy committee.

This article is for information and does not constitute advice. The value of investments and the income generated from them, can go down as well as up and your capital is at risk.