The Bank of England now forecasts inflation will hit 7.25% this spring. This is another significant upward revision for the central bank. And yet in its February Monetary Policy Report, the Bank still reassures us that the inflation rate will return to the targeted 2% by 2024.
So, why are policymakers still confident that this inflation is transitory? Firstly, they view the energy shock as another temporary inflationary force. They argue that in the short term it will push up the price of goods and demand will remain strong. However, they argue that the energy shock will ultimately damage demand more than push up company costs, as income will not rise in line with inflation.
Secondly, since inflationary whispers began to circulate at the end of 2020, the core counter-argument has been that it is primarily driven by supply chain bottlenecks, which will resolve themselves as economies reopen.
Longer-lived than hoped
However, we think that many of these supply chain issues may be longer-lived. For years, an increasingly globalised world has led firms to focus on efficiency within their businesses. Companies have continually decreased inventories, enabling them to squeeze out better margins.
The problem is that central banks continue to pursue an exceptionally accommodative monetary policy. Investors are fretting over the prospect that the Bank of England may raise rates several times this year. However, even if rates rose to above 1% in the UK, they would still be starkly negative once adjusted for an inflation rate of well above 5%.
To keep a lid on inflation, economies need materially higher rates. But, with both high private and public levels of debt, markets and governments are not braced for this environment. Central banks are stuck between a rock and a hard place: raise rates and potentially destabilise financial markets; or keep them low, allowing inflation to continue unshackled.
Growth in wages is the force that will likely embed inflation most into the system. While we have seen significant nominal wage growth, we may see this come through in real terms too.
As a cost-of-living crisis is emerging, we hope that the Bank of England’s forecasts are accurate. However, its constant upward revisions do not engender confidence, and its ability to act decisively seems questionable.
Alexander Johnstone is an investment associate at Ruffer
Ruffer LLP is a limited liability partnership, registered in England with registered number OC305288 authorised and regulated by the Financial Conduct Authority. The information contained in this article does not constitute investment advice or research and should not be used as the basis of any investment decision.