The narrative over ‘temporary’ inflation could soon be blown apart by structural changes to services and labour in the UK according to James Lynch, fixed income investment manager at Aegon Asset Management.
“We know there was a huge shock to the labour market in March 2020. The fallout of which was jobs lost in sectors heavily reliant on human interaction, and many others being artificially supported by the furlough scheme.
“As Ben Broadbent (Deputy Governor BoE) highlights in his ‘mismatch’ speech on 22nd July, the next part of the economic recovery, where demand will naturally shift away from goods consumption and back to services, to result in workforce changes which he believes will not be easy and may create problems.
“So far, the inflation story can be explained away by the idiosyncratic factors in goods prices. But when the reallocation of labour goes back to services at an unprecedented pace there will be mismatch problems in finding the right workers in the right jobs, this has the potential to lead to higher wages which could be more long lasting.
“The reallocation of supply and demand away from goods to services will take place along with an overall increase in aggregate demand thanks to excess household savings being drawn down, so we could see increasing services inflation as well as goods price inflation still working its way through the economy.
“There will be an aggregate demand increase coming through in the UK with the end of restrictions, savings being spent and the return of furlough workers. Some two million people will start to come back to the labour force, but unfortunately not all. However, offset against the increase in the supply of labour from furlough workers to help GDP growth will be the persistent fall in EU nationals, which is more of long-term story but sped up by Covid-19, and in the short-term the high levels of self-isolation leading to a fall in labour supply.
“The isolation of 600,000 people a week is not good for GDP growth and is causing real issues along the supply chain, but – given the only thing that has changed is the rise in cases causing the isolation rather than a change in the test and trace app criteria – the case load data is the biggest variable to this.
Lynch believes that whilst the picture is very unclear, by September market watchers should begin to get a better idea of what the economy is really doing. This he says, will have implications for monetary policy decisions by the Bank of England.
“The outlook is highly uncertain, but we are getting closer to judgment day. With distortions in the data thanks to furloughed workers, base effects on year-on-year comparisons, and changes in the make-up of the labour force. In totality it makes for an extremely unclear picture of what inflation and wage growth is really doing.
“The Bank of England’s Monetary Policy Committee will want to wait and see rather than make a judgment beforehand. The problem for the MPC is that after the 4th of August meeting, the next Monetary Policy Report meeting is on the 4th of November.
“In this environment that feels a long time; the economy is changing at a faster pace than it ever has done. As investors, we’re watching and waiting to see if the 23rd of September meeting might become more important as we should know a lot more by then.”