The Investment Series: Economic Recovery & Inflation

With the global vaccine roll out in full swing and a staggered return to normality in sight, governments around the world are hard pressed on getting their economies back up to pre-pandemic levels of output. The public health catastrophe of COVID-19 has put the economic status of many nations in less than ideal positions, calling for unprecedented fiscal roll outs, borrowing and for some a dependency on international aid.

The markets need recovery and they need it fast! However, getting the global economy pumping again is easier said than done in the best of times. Unfortunately, for our decision makers, the road to post-covid recovery does not come without its potholes: one of them being inflation.

Image Source: Financial Times

What is inflation?

According to Investopedia, inflation is the rate at which the purchasing power* of a currency falls and consequently the general level of prices for goods and services is rising. Put simply, it is the rate at which prices for goods and services in an economy increase over time.

(*Purchasing power measures the amount of goods and services you can purchase per pound.)

Inflation is a key indicator of economic-wellbeing and is something governments and central bankers earnestly aim to keep in check. In the UK, the Bank of England targets an annual inflation rate of 2% – many other major economies also aim for this figure. This means the general price for goods in the UK should rise by 2% each year. Low and stable inflation is a good thing as it pushes consumers to purchase items today rather than in a year when prices are higher. This increases Gross Domestic Product (GDP) and results in economic growth.

The most widely used measure of inflation is the Consumer Price Index (CPI). Without getting into the technicalities, the CPI identifies the price changes of a ‘basket’ of consumer goods year on year. Consumer goods are everyday items that are bought by individuals like you and I. Bread, phones, cars – the whole lot. Other measures of inflation include RPI and CPIH.

Finally, inflation is typically caused by three main drivers: demand-pull, cost-push, and built-In inflation (AKA the ‘wage-price spiral’). For the purposes of our post-pandemic understanding of inflation demand-pull and cost push inflation will be most relevant.

How Does Inflation Work?
Image Source: Melissa Ling © Investopedia, 2019

Post-pandemic inflation

The US Treasury Secretary recently disclosed to City A.M. that “inflation could reach as high as three per cent this year as the economy rebounds from the worst of the pandemic”. Similarly, a source from The Bank of England advised the tabloid that “inflation is heading above its two per cent target in the UK and will hit 2.5 per cent at the end of 2021”.

Inflation is here, and as the Office for National Statistics (ONS) would like us to believe – it’s here to stay. But why?

Well, slingshotting out of a near economic standstill creates the perfect environment for transitory inflationary pressures. Since we are now in a position where we want to get the productive ball rolling, the supply of goods and services just isn’t able to keep up with demand. Here lies the phenomena of demand-pull inflation, the upward pressure on prices that follows a shortage in supply. A condition that economists describe as “too many dollars chasing too few goods.”

Over the past 15 months there has been an increase in personal savings around the world, compounded by record levels of fiscal stimulus notably; Joe Biden’s $1.9tn (£1.3tn) rescue package. In our anticipated post-pandemic reality, now is the time to spend – and spend we must! But with a shortage of goods caused in part by supply chains that are still warming up – prices are sure to increase across the board.

For us in the UK, our supply chain woes are made additionally onerous due to the impact of Brexit on goods imported from our biggest trading partner the EU. A recent study by the University of Sussex, found that up to £3.5bn of British exports had taxes applied, which accounts for about 10% of British goods exported to the EU.

The sector advisor, Anu Kuhanathan, at Euler Hermes said, “Most sectors are experiencing some degree of pricing pressure from rising material costs – stimulated in large part by the ongoing impact of Covid restrictions as well as Brexit-related import challenges at a time when consumer demand is surging.” These additional costs of importing goods introduces us to the second main driver of inflation: cost-push inflation.

Cost-push inflation occurs when overall prices increase due to increases in the cost of wages and raw materials. If it costs more to produce or supply goods/services, then prices will increase to reflect this (unlucky for us at the bottom of the retail food chain!). Since the cost-push theory assumes that demand for goods remains unchained, it is in our view that demand-pull and cost-push drivers are acting on prices at the same time.

Inflation
Image Source: Julie Bang © Investopedia 2019

The Bottom Line

Overall, inflation is going to be a prominent transitory feature on the road to recovery. I am convinced that this is to be expected and, ideally, should not present any major long term problems. Markets Editor at the Financial Times, Katie Martin said, “it would seem that the markets have also taken this view.” So, if the markets aren’t yet in a state of inflation led panic, neither should we – at least for now!

Thankfully, in a worst case scenario, there are tools available to governments to rein in inflation where necessary: by raising interest rates. With the Bank of England interest rate currently at 0.1%, this is a policy muscle that could possibly be flexed again in due course. Though our counterparts across the Atlantic, The Federal Reserve (The Fed), have already given clear indication that it is willing to let inflation run above its 2% target, in its attempts to “encourage a strong recovery from the pandemic”.

Seems The Fed has got the right idea. Let’s just hope things go according to plan!

Best,

Ayo and Tom


Tom is a Economics graduate from Loughborough University and has recently completed his Masters in Finance & Private Equity at the London School of Economics. Tom has a deep interest in the financial world and is keen to make his mark in the industry.

Please feel free to get in contact with Tom directly via his LinkedIn profile below.

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