InvestmentsMar 3 2021

BoE's Haldane on why inflation 'tiger' could be hard to tame

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BoE's Haldane on why inflation 'tiger' could be hard to tame
Jason Alden/BloombergBank of England chief economist Andy Haldane

Inflation in the UK could rise sharply and remain persistently higher over the coming decades, according to the Bank of England's chief economist

In a speech published by the Bank of England last week, Andy Haldane said he expected inflation to reach its 2 per cent target around the middle of 2021 as the one-off effects of Covid-19 are "washed out".

Inflation, currently at 0.9 per cent, has been below its 2 per cent target since August 2019 and has been entrenched at a lower level for several years.

Haldane pointed out that, having averaged around 10 per cent in the 1970s and 1980s, inflation fell to around 5 per cent in the 1990s, just below 3 per cent in the 2000s and around 2 per cent in the 2010s.

But he cautioned against complacency, predicting this could change in the near future due to rising demand as economies re-open following the coronavirus pandemic.

Haldane said: "My judgement is that we might see a sharper and more sustained rise in UK inflation than expected, potentially overshooting its target for a more sustained period, as resurgent demand bumps up against constrained supply."

He described inflation as a "tiger" that had been stirred by the events of 2020.

Haldane warned: "For me, there is a tangible risk inflation proves more difficult to tame, requiring monetary policymakers to act more assertively than is currently priced into financial markets.

"People are right to caution about the risks of central banks acting too conservatively by tightening policy prematurely. But, for me, the greater risk at present is of central bank complacency allowing the inflationary (big) cat out of the bag."

Output gaps

The rate of inflation in any economy is heavily influenced by the output gap, which is the difference between the potential level of growth an economy can achieve in normal conditions, and the level actually being achieved. 

As long as economies are operating substantially below their rate of potential, inflation should not take hold, because, with more supply than demand in the economy, there is no capacity for prices to rise.

Haldane says the output gap in the UK, as brought about by the pandemic, is lower than the output gap  during the global financial crisis because while some sectors saw demand plummet, others saw it rise sharply.

The tech-heavy Nasdaq index, which does best when inflation expectations are low, has started to under-perfom relative to the FTSE 250, which tends to do best when inflation expectations are high

Haldane added that the response from central banks to the pandemic - such as cutting interest rates to the historically low level of 0.1 per cent - coupled with increased spending by the government has far exceeded the response to the financial crisis.

This means it is possible policy makers might inject too much stimulus into the system, which means economies start to operate at above the level of their long-term potential, or overheat, which causes higher inflation. 

Haldane said the £450bn of quantitative easing injected into the system since the pandemic began is already more than the entire amount of QE deployed in the decade after the financial crisis. 

He added the enforced saving brought about by lockdown means there is about £150bn of cash held by consumers, and £100bn of cash held by consumers, which is unspent. 

Interest rates 

A scenario where the economy is over-heating might lead to interest rates rising at a faster pace. These fears caused February's sharp sell off in assets most sensitive to inflation, such as developed market government bonds and technology shares.

US Treasury yields have been rising recently, an indicator the bond market has started to price in higher inflation

But, in addition to cyclical factors, Haldane believes the longer-term outlook could also be for higher inflation, after a period of decades where inflation drifted lower.

He said one of the factors which contributed to lower inflation over recent decades, such as globalisation and a young UK population, were reversing.

Globalisation, and specifically the outsourcing of manufacturing to China, reduced inflation by making goods cheaper, but Haldane believes the pandemic could bring manufacturing back to domestic markets, resulting in higher prices.

Haldane said a larger portion of the population being of working age is deflationary because it means there is more competition for each job but he said the proportion of the total population that is younger will fall in the coming years, creating wage inflation. 

George Lagaris, chief economist at Mazars, disagreed with the idea inflation could become an issue over anything more than the short-term.

He said: “The year-on-year effect will pass, global supply chains will eventually repair themselves and demand will probably flatten out after the initial post-lockdown boost and the withdrawal of fiscal stimulus.

“In fact, governments are getting ready to end Covid-era fiscal easing for fear of an increased debt burden.

"Investors would do well to remember that this environment, where additionally unemployment could well remain elevated vis-à-vis pre-crisis levels, is hardly conducive towards long-term inflation.

"With risks in fact mostly on the deflationary side and the need to manage global debt levels, we expect the big central banks to remain active in steering risk assets for the foreseeable future."

Andrew Hunt, of consultancy firm Hunt Economics, said UK government policy during the pandemic has focused on the supply side, that is, keeping the suppliers of goods and services in existence, more than the demand side.

This creates a substantial output gap, because the number of suppliers of goods and services in the economy remains large, while demand dwindles. If the economy re-opens and people spend their savings, that closes the output gap quickly but doesn't lead to inflation as supply will remain plentiful.

david.thorpe@ft.com