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Our views 02 May 2023

JP’s Journal: Inflation is a funny thing

5 min read

Inflation is a funny thing. We observe price levels in everyday life, not the rate of change in those prices.

If we look at forecasts for inflation for the next 12 months, the consensus is for a hefty fall in the second half of the year, taking inflation near to the Bank of England’s (BoE) inflation target of 2%. If this is right, the above-target inflation spike would have lasted just over two years. In a historical context, quite a short period of time. But on the ground, it will feel different. Let’s take the last five years of Consumer Price Index (CPI) inflation data in the UK. Back in March 2018, inflation was around target. It fell through 2019 and 2020 – remember those fears of deflation and negative interest rates? The pick-up in inflation predated the Russian invasion of Ukraine, being a response to the monetary and fiscal stimulus during Covid and then the end of lockdowns. So, through the second half of 2021 inflation was rising, hitting 5.4% at the end of that year. War and sanctions pushed up energy and food prices through most of 2022, with CPI making a high of 11.1% in October. We have subsequently seen a small decline in inflation, to the present level of 10.1%.

Let’s look at that in another way. Over the last five years CPI inflation has averaged just over 4%, double the BoE target. This means that the actual price level (CPI index) is 22% higher than it was five years ago. If the BoE had delivered 2%, the price level would have been 10.4% higher. So, even if inflation returns to target later this year, actual prices will still be significantly higher. What this means, in my view, is that the pressure for higher wage settlements will remain even as inflation falls.

The BoE’s chief economist got a lot of flak last week for suggesting that people need to accept that they are worse off and stop trying to maintain their real spending power by bidding up wages. From an economist viewpoint, this was an entirely rational response. From the perspective of families, it looks unreasonable. In practice, it means that interest rates will have to go up again – after all, the BoE remit is inflation, not growth, unemployment, or inter-generational impacts.

I had a breakfast meeting last week with Brian Friedman, President of Jefferies Financial Group. A really nice guy with great insights into corporate America and having a truly global perspective. At a high level, what struck me was the dynamism of the US and the shifting global economic realities. But, from my perspective, there is a cloud on the US horizon: its debt mountain and the looming problem of the debt ceiling.

The US has prospered despite its politicians – not because of them. We are now seeing the polarisation of politics playing out in relation to the US debt ceiling. Treasury Secretary Janet Yellen has warned that the debt limit will be reached imminently. The US Treasury has about $310bn spare cash but this will run out by early June.

A quick reminder: the ceiling is a legislative limit on the amount of debt that can be incurred by the US Treasury. When the debt ceiling is reached without an increase in the limit being agreed, the US Treasury will need to resort to ‘extraordinary measures’ until a resolution can be reached. Ultimately, a default on government bonds could occur after the exhaustion of these ‘extraordinary measures’. This would challenge the 14th Amendment of the United States Constitution which states that "the validity of the public debt of the United States...shall not be questioned."

In reality, the debt ceiling debate is a political struggle between Democrats and Republicans as election campaigns move into gear. There appears to be no chance of an agreement to raise the ceiling unless Democrats offer concessions. The most likely outturn is a deal to raise the ceiling accompanied by spending cuts and tax increases. It appears that Republicans have rediscovered fiscal prudence.

There is a sense of déjà vu; we have been here before after all. But political agonisms are high, no Republican wants to be seen as a ‘sell-out’ and the debt mountain is growing at nearly $100m an hour. I do not expect any missed coupon payments on US debt – if there were, it’s a whole new ball game. But even politicians can’t be that stupid.

The looming failure of another bank did not have much impact on the US treasuries, with 10-year yields remaining around 3.6%. European markets were better: German and Italian rates were lower by 20bps. In the UK, 10-year yields ended at 3.7%, 8bps lower over the week. Implied inflation fell across the board – in the US the 20-year breakeven rate is just below 2.3%.

Investment grade credit markets continue to hold in well. In sterling, credit spreads were a bit tighter although there was not much change in high yield markets. There continues to be good demand for longer dated, more highly rated credit bonds, reflecting annuity buying.

Back to the debt ceiling. It should be pointed out that debt mountains are not just the preserve of the US. In the UK the debt / Gross Domestic Product ratio is closing in on 100% and this looks low compared to the ratios in France and Italy – and let’s not mention Japan. The real impact of these debts is now becoming apparent as we move away from near zero interest rates. At some point the debt servicing costs in the UK will replace education as the third largest expenditure item. Perhaps the toleration of a bit more inflation may be welcome if it reduces the real value of debt – except that interest rates will be that much higher as well. To my mind, a bit more insurance through index linked bonds looks appropriate.


This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.