Wages
Wage growth is also a key plank of inflationary fears, and is currently running hot at around 6.6% at the last ONS reading in May. Again though, this annual figure is distorted by the pandemic effects on the labour market. Many of the jobs lost during the pandemic were lower paid roles in the hospitality sector, which has skewed the arithmetic of average wages upwards. As these roles return to the workforce, this should act as a brake on average wage growth going forward. Furlough has also played a big part in stoking wage inflation. Last May, 8.4 million workers were on furlough, according to government figures, compared to 2.4 million this May. That’s an awful lot of people going from receiving 80% of their salary to 100%, and that clearly exerts upward pressure on annual wage growth figures, yet it’s not a gain we can expect to be repeated year on year.
Source: ONS
Fiscal policy
The Treasury is currently pumping lots of money into the economy to prop it up in the face of the pandemic, but the hand that giveth will become the hand that taketh away. In the short term, policies like the furlough scheme, business rates relief, and the super deduction for capital expenditure are costing the Exchequer huge sums of money. That money is going into the hands of consumers and businesses, enabling them to buy more goods and services, potentially adding to an inflationary spiral. But from 2023 onwards, the government is clawing large amounts back from businesses and consumers, mainly through freezing tax allowances, and raising corporation tax. By withdrawing money from the economy to balance the books from 2023 onwards, fiscal policy should start acting as a brake on inflation, rather than adding fuel to the fire.
Source: HM Treasury
Central bank firepower
With bank rate so low, the central bank has lots of potential to fight off inflation with interest rate rises, or by withdrawing QE. That would inflict pain on mortgage borrowers and businesses with large debts to service, however the toolkit is there to deal with rising prices. On the other hand, the Bank doesn’t have much room to manoeuvre by cutting interest rates in the event of an economic downturn, so that means the bank will likely err on the side of stoking inflation, rather than risking undermining economic growth.
The case for inflation
While the factors outlined above should help to contain inflation, there are also forces pushing in the opposite direction. Fiscal and monetary stimulus are currently abundant, and if combined with a synchronised global economic recovery from the pandemic, could sow the seeds for an inflationary period. The fact that central banks are willing to look through rising prices also adds to the risks, as if sustained inflation is taking hold right before our eyes, rate setters will be late in taking action to deal with it.
Investors therefore shouldn’t be complacent about inflation, and their portfolios may well be skewed towards investments which won’t perform well in an inflationary period. The low interest rate environment we’ve seen in the last decade or so has led to a ballooning in the value of assets that thrive in a low inflation environment, and conversely might struggle if inflation takes off. Chief amongst these are long dated government bonds, and also investments that can act as bond proxies, such as reliable, high quality, blue chip companies. The benign inflationary environment has also created the perfect conditions for growth stocks, particularly in the tech sector, where the appeal of foregoing profits today in favour of profits tomorrow is not heavily eroded by high rates of inflation while you wait. These investments may well still warrant a place in pensions and ISAs, but their strong performance means they may now make up an outsized proportion of portfolios, which potentially leaves investors at risk from an inflationary shock. Some reallocation of profits may therefore be in order. So far, the case for and against inflation is finely balanced, and that suggests investor portfolios should be too.
