Will inflation give way to deflation?

Rising prices, growing gilt yields, higher interest rates and stagnant pay present a bleak economic picture - but a different problem may be on the horizon.

Towering columns

In the Daily Telegraph Ambrose Evans-Pritchard says high inflation will soon end, but then we must contend with the danger of deflation:

The global inflation shock of the last two years is over bar the shouting. Legacy effects will generate much noise for a few months but the one-off spike is reversing almost everywhere with an elegant symmetry. China is sliding into outright deflation as its post-Covid recovery peters out. Wage cuts are spreading in a surreal replay of what happened in Europe and America during the 1930s. Such is the Spartan ethos of Xi Jinping’s ‘common prosperity’ campaign. The Chinese producer price index has been negative for seven months, and the downward slide is accelerating. The headline CPI inflation rate has already dropped to 0.1pc and will soon be negative. The Shanghai region is at minus 1.1pc already. This has large implications. China remains the workshop of the world, with the scale to shift the global pricing structure. It needs to export its way out of an economic depression and will not hesitate to do so with a cheaper yuan, down 12pc since early 2022. A wave of disinflation is coming our way…

[China is] already beginning to export deflation, as you can see in the cut-throat price of electric vehicles arriving in Europe… Chinese goods deflation is hitting a slowing world economy… Europe’s recession seems to be spreading, sucking in France as property transactions freeze and real consumption hits a brick wall. In its infinite wisdom, the European Central Bank is once again tightening hard after the onset of recession. It has pre-committed to further rate rises in June and July and will no doubt persist for the sake of ‘credibility’.

The UK may be one of the last inflationary outliers for a month or two, although it is not so different from Germany or Sweden. Global forces will bring it into alignment with the OECD median soon enough. We are not an economic island. Rishi Sunak will have no difficulty cutting inflation to 5pc by the end of the year. Unfortunately this happy development may come hand in hand with our old friend ‘secular stagnation’. Will deflation be the greater worry in 2024 after all?

In The Times Juliet Samuel has questions for the Bank of England:

It’s likely our Bank will soon be forced to raise rates further, even though it brings up a host of thorny issues. Among the most pressing is the gilt market. Government borrowing costs have shot up to levels last seen during the Liz Truss debacle as rising wages and food prices convince markets the Bank will have to keep going. Although the rate rise is more orderly this time, thanks to cautious government rhetoric, there could yet be booby traps ahead of the kind that did for Truss, when pension funds suddenly became forced sellers of gilts.

This is especially tricky for the Bank because it is also trying to sell off the stock of bonds it bought during various rounds of its money-printing programme, quantitative easing (QE). Other central banks engaged in quantitative tightening, as it is known, are simply holding the bonds until they mature. But the Bank has decided, seemingly with less analysis and fewer caveats than the US Federal Reserve, to adopt a more radical approach. Given the degree to which QE has rewired the banking system, this is a risky operation. Closely behind gilts in the hierarchy of problems is the state of the mortgage market… Aside from this, there’s the question of whether we have entered a new era of repeated shocks to supplies of goods. The rise in food costs has yet to slow. The government has done almost nothing to protect us from further energy shocks. And we have yet to understand the knock-on effects from the US, EU and China’s mutual attempts to reduce their interdependence…

The malaise at the Bank should worry Rishi Sunak. He has, after all, made two prominent pledges entirely reliant on its judgment. He will, he has said, halve inflation and avoid recession. Quelling inflation is, of course, a matter for independent monetary policy and his own chancellor has said that recession is a price worth paying to achieve it. In other words, the prime minister has set himself up to be judged by the institutional health and success of our central bank. He and the chancellor have only one lever they can pull to affect any of this, which is to improve its governance. Instead, they have left it on autopilot. No doubt, when the time comes, they will reach quickly for the Bank’s tried and tested excuse: “Sorry we failed. The factors at play were outside our control.”

In the New Statesman, David Gauke says rising gilt yields do not prove - as some now suggest - that Liz Truss was “right all along”:

With two-year gilt yields reaching levels higher than in the aftermath of the mini-Budget, [some now say] Sunak is no better than Liz Truss in maintaining the confidence of the markets. This argument comes from two directions. Labour wants to damage Sunak’s reputation for being a reassuring influence on the markets; Truss apologists want to argue that the market turmoil of last autumn was not really her fault, that high gilt yields happen and that there was nothing particularly catastrophic about her time in office. Neither position is valid.

The market behaviour of last autumn reflected not immediate concerns over inflation but anxiety over the longer-term sustainability of the public finances. This was caused by a fiscally reckless mini-Budget and a destructive approach to our independent financial institutions. That is why the big increases in yields were for longer-term borrowing. Truss and Kwasi Kwarteng spooked the markets, which then caused further turmoil by triggering leverage problems for pension funds, making a bad situation worse.

What has happened with gilt yields is not evidence that the Prime Minister has lost the confidence of the markets. Nor is it evidence that Truss didn’t lose the confidence of the markets. It is revealing that the pound is currently strengthening when last autumn it was collapsing. Truss was directly culpable; Sunak is not (even if hard-pressed mortgage holders may not draw the distinction). 

In the Financial Times Martin Wolf says our pension system needs to be reformed to increase investment in UK equities and returns for savers:

As a result of a series of narrow, short-sighted and overly theoretical decisions, the UK has ended up with a pensions system that is incapable of generating the supply of long-term risk capital on which development depends or of providing the population as a whole (not just a few favoured groups) with adequate and secure pensions. Symptoms of this disaster include a moribund stock market, under-invested companies, an undue dependence of foreign capital and even a stagnant economy. The origins and consequences [include] … in particular, the narrow focus on making pension promises absolutely safe made them unaffordable. This crippled the businesses liable for these exorbitantly expensive promises. It also deprived new businesses of the risk-taking capital they needed. Finally, as defined benefit plans collapsed, the public was pushed into defined contribution plans that impose too much risk for individuals to manage easily. None of this matters in fantasy financial economics, in which borders are unimportant, domestic investment is independent of domestic savings, corporations have frictionless access to liquid financial markets and markets are rational and far-sighted. But these are fairy stories, not a reflection of reality.

Between 2001 and 2022 … “UK private sector pension fund holdings of UK equities fell from an average of 50 per cent of the portfolio to just 4 per cent today. Over the same period, their holdings of fixed-income securities (mainly gilts and corporate bonds) increased from 15 per cent of total assets to approximately 60 per cent.” Not surprisingly, with companies forced to use their cash flows for filling the nearly bottomless pit of pension fund deficits, rather than investing, the businesses became ever less dynamic. The UK stock market’s performance has been startlingly bad relative to those elsewhere. But the market is moribund because the corporate sector has become a zombie. Who has benefited? The answer is pension consultants, insurance companies (profitably picking up the pieces) and the government, enjoying a captive source of ultra-cheap funding. Meanwhile, the returns of such defensively managed pension funds have been far below those otherwise possible.

In the Daily Telegraph, Mustafa Latif-Aramesh and Angus Walker insist that we must reform the planning system and get Britain building again:

While there have always been complaints that “planning” is the problem holding up delivery of energy and transport developments, this particular regime has slowed down over time. There are several reasons for this. One is that environmental assessment, where developers must set out the expected environmental impacts of their projects, has become more and more onerous. This is not through changes to legislation but simply a raising of expectations from those affected and an increased risk-aversion by developers. Environmental statements setting out expected environmental impacts and how these will be minimised used to be hundreds of pages long. Their page counts now run into the tens of thousands. While not exactly comparable, the Jubilee Line extension environmental statement was shy of 400 pages. Sizewell C was 44,000…

A second issue is that developments are measured for compliance against (supposedly) current statements of transport and energy policy. These have not been updated by the Government for many years. Energy policy for these purposes is currently frozen in time from 2011 and transport policy today reflects the situation in 2012, 2015 or 2018, depending on which mode of transport you look at. Yet while planning rules remain frozen, wider changes are pounced on to pursue environmentally based judicial reviews; the introduction of net zero in 2019 stands out as the most obvious example…

A third issue is that the Planning Act 2008 introduced what were supposed to be fixed timescales for different stages of the authorisation process, but included a last-resort provision to allow extensions of time in exceptional circumstances. All was well with the regime for the first six years or so, with only one project being extended in that way, but now the Government extends its own decision-making stage for over 50 per cent of projects, sometimes for more than a year. Everyone else, particularly the Planning Inspectorate, has largely kept to their side of the bargain at the earlier stages… A final area causing delay, and with scope for improvement, is the role of environmental and other regulatory bodies. These have a vital role to play in scrutinising applications, but are increasingly under-funded and cannot properly play their roles in the regime. They often find it easier to register objections than to suggest solutions. Funding by a developer for a particular project is not the answer; even if a developer pays out, regulatory bodies cannot instantly conjure an expert in the relevant field. Consistent, long-term funding is needed.

In The Times, Tomiwa Owolade says when it comes to race, we have to stop talking like America:

It is easier to have exclusively black friends in America than it is in the UK because there are many US cities where the majority of the population is black … By contrast, London is the city in Britain with the highest concentration of black people and they only make up 13 per cent of the city’s population. Any comparison between black people in America and black people in Britain that fails to consider these demographic differences is short-sighted. Britain’s political institutions, history and many of its cultural values are different from those in America, so why should we assume that race would be the same in the two countries? When we think about race and racism, we need to think about the groups that are affected by these things. They are not simply interchangeable pegs to be slotted into a machine. They are human beings richly embedded in their own particular communities. Emphasising that humanity needs to form a key part in any anti-racist vision.

Despite the racism many black Britons have faced at home, the Windrush generation and subsequent generations have developed a strong cultural affinity with the nation. To define them wholly through their terrible experiences is a form of denigration: it denies their attachment and contribution to Britain… We need a new conversation on race in Britain. What is at stake here is the dignity of black people. We need to stop seeing them through the prism of American racial politics or through an abstract lens that emphasises their blackness over their Britishness. If we don’t, it will stop us from precisely identifying the racial inequalities in our society — the issues that face black and other ethnic-minority Britons. It also undermines another case for anti-racism. Racists think black people cannot be British; that they are black before they are British. They are wrong. And this should be central to any form of anti-racist politics. Without it, we cede to the racist argument that black people are inescapably foreign to Britain. This is not America; black British lives matter.

Wonky thinking

The Tony Blair Institute for Global Leadership has published a report, with a foreword by Tony Blair and William Hague, on how Britain can secure its role in an AI economy:

This report describes what this country will need to do to be a world leader in the safe and successful development of artificial intelligence (AI), a matter becoming so urgent and important that how we respond is more likely than anything else to determine Britain’s future. Such global leadership will require a major speeding up and scaling up of the welcome initiatives already announced by the UK government. For instance, we call for the planned increase in the UK’s compute capacity to be ten times greater than currently envisaged, and for the government to reach exascale capacity within a year, rather than 2026. We argue that major spending commitments should be reviewed to divert funds towards science-and-technology infrastructure as well as providing the talent and research programmes necessary to be a global leader in AI.

Our report provides a comprehensive plan for the overhauling of government machinery, including how ministers are advised; bringing necessary expertise into government; ensuring the public and private sectors can work closely together; insisting that research and regulation proceed in tandem and in an agile way; and for building up sovereign capabilities that will be vital in providing effective guidance and regulation. We renew our call for an Advanced Procurement Agency to encourage innovation, describe how training and education could be revamped, and for urgent work on using AI to improve public services.

For the UK to be at the forefront of global thinking on AI, we call for a national laboratory to work with the private sector and other nations on its safe development. We suggest how the UK government, working with the United States and other allies, could push for a new UN framework on urgent safeguards. We describe what should be done to tackle the immediate threat of widespread disinformation. And we set out how the UK could, while working with the European Union, develop a model of regulation aligned with US standards that becomes highly attractive for startups, bringing talent and investment to the country.

For the Institute of Government, Sam Freedman and Rachel Wolf examine the NHS productivity puzzle:

NHS hospitals in England are struggling to manage both emergency and elective admissions. In February 2023 more than 125,000 people, 10.6% of those attending, had to wait more than 12 hours in A&E, a situation one experienced health expert described as “apocalyptic”. A decade earlier, in February 2011, just 40,800 people had waited more than four hours, 2.9% of those attendees. It wasn’t until the winter of 2014 that the four-hour wait percentage rate dipped below the 95% target, but it never really recovered. In December 2019, just before the pandemic hit, the figure stood at just under 380,000, or 20.2% of attendees. By December 2022, after the pandemic, four-hour wait figures reached a nadir of 700,000 (35%). Winter 2023 looks set to be similar if not worse.

Full A&E departments had knock-on effects across the system. In December 2022 ambulances backed up in queues around hospitals leading to record mean response times for a category 2 ambulance call – covering issues like strokes and chest pains – of 90 minutes. Ambulances were forced to adopt new procedures to drop patients off regardless of whether there was A&E capacity. The Royal College of Emergency Medicine has estimated that these problems within A&E led to 23,000 excess deaths in 2022 alone, about 3% above average. Excess deaths in 2023 remain high – 8% above the five-year average (which includes the pandemic years).

American Compass has published Rebuilding American Capitalism: A Handbook for Conservative Policymakers. In the foreword, Oren Cass writes:

Conservative economics, unlike the fundamentalism that supplanted it for a time, begins with a confident assertion of what the market is for and then considers the public policies necessary for shaping markets toward that end. The conservative conception of the common good requires a free-market economy in which all people can choose their own life course and through their own efforts contribute productively to their communities, support their families, and raise children prepared for the same. This is a richer notion of freedom, attached to obligation, recognizing that with economic rights come economic responsibilities.

In this conception, the economy serves not only the family and community, but also the nation. Efforts to dissolve borders and construct a more efficient global market devalue the nation-state, weaken its sovereignty, and reduce the citizenry’s democratic control. And notwithstanding liberalism’s one-world ideals, leaders in many other countries remain firmly committed to operating on behalf of their own national interests. If America pursues global supply chains while China pursues national ones, the result will be Chinese supply chains.

The conservative vision thus requires that markets not only allocate capital to productive uses and serve consumers at the lowest possible price, but also create the range of secure and dignified jobs in which people of varying aptitudes, with varying interests, in varying places can build decent lives. Over time, the market must produce growth that is widely shared and sustainable—a term coopted by the environmental movement but applicable as well to other foundations of a free and prosperous nation that market forces will tend to erode. The industrial commons requires protection, to ensure that its capital base, talent pool, and centers of innovation fuel productivity gains and provide for the national defense. So does the labor market, to ensure that the nation’s workers are essential to economic success and prepared for contributing to it. So does the social fabric, to ensure a sense of place, caring relationships built on mutual obligation, and the solidarity to solve problems and counter threats.

Book of the week

Our recommendation this week is The Price of Time: The Real Story of Interest, by Edward Chancellor, who argues that unconventional monetary policy has been a disaster for economic growth and opportunity:

Economists reveal their physics envy by their choice of metaphors. In physics, escape velocity refers to the speed necessary to escape from a planet's gravitational pull, remarked the Bank of England’s Governor Mark Carney in early 2014. The economic analogue is the momentum necessary for an economy to escape from the many headwinds following a financial crisis. With these words Carney justified keeping the Bank’s policy rate at close to zero. As it turned out, the British economy during Carney’s time as Governor (he retired in 2020) never achieved escape velocity. Could it be that the monetary policy experiments after the Lehman crisis did more harm than good? That was the view of PIMCO’s ‘Bond King’ Bill Gross, who, displaying his own science credentials, suggested that just as Newtonian physics breaks down at the speed of light, so a market economy ceases to function normally when interest rates approach the zero lower bound…

Gross pointed to UK bank-branch closures and staff lay-offs, zombie companies and blockages in the financial plumbing induced by the Fed’s massive Treasury bond purchases. Low yields, low carry, [and] future low expected returns have increasingly negative effects on the real economy ... Perhaps zero-bound interest rates and quantitative easing programs are becoming as much of the problem as the solution, Gross wrote in the summer of 2013. Five years later, two American economists published a paper modelling the losses suffered by banks when policy rates fall below a certain level. Markus Brunnermeier and Yann Koby named this tipping point the ‘reversal interest rate’. (The tipping point varies from one banking system to another, but occurs when interest rates are above zero.)

As Gross pointed out, banks need a positive lending spread (net interest margin) to encourage them to advance loans. If banks don’t lend, they don’t create money either. Quantitative easing boosted asset prices and shrank credit spreads, but most of this newly created money wasn’t lent to consumers or businesses but was deposited by the banks at the Federal Reserve. The fact that the Fed in 2008 started paying interest on excess reserves (i.e. bank deposits at the central bank) gave banks even less reason to lend. The circulation of money through the economy slowed. In short, the Fed’s policy of keeping rates close to zero didn’t create inflation, but rather produced a lingering deflation…

… cheap trade credit encouraged firms to construct longer supply chains, which, in turn, reduced the prices of traded goods. The proliferation of corporate zombies further added to deflationary pressures. Many industries faced chronic excess capacity. Corporate debt soared in the United States after 2008, but much of this lending was directed for financial purposes - whether share buybacks or leveraged buyouts. Low interest rates fuelled a takeover boom, which reduced competitive pressures and fostered monopolies and oligopolies. Since zombies, monopolies and financialized firms tend to invest less, collectively they lower the economy's innate capacity for growth.

Ultra-low rates also undermined the economy from the demand-side. It is all very well to pull consumer spending from the future into the present, but in the long run households with large debts and inadequate savings must spend less in future. That’s what happened after 2008, when American and British households started to pay off some of the excess debt contracted during the credit boom. To some extent, the deterioration of household balance sheets was concealed by the soaring stock market and other asset price bubbles. But… by raising the cost of retirement liabilities, discouraging savings and lowering returns on pension investments, the low-interest-rate regime sent future consumption on a downward trajectory.

Besides, the main beneficiaries of the great wealth bubble were the 1 per cent, while the rest of the 99 per cent struggled with weak income growth, unaffordable housing and excessive debts. Rising inequality, as economists never tire of pointing out, is not good for economic growth - especially the bad inequality that arises from corporate rent-seeking of the type which thrived after 2008.

Although ultra-low interest rates and massive securities purchases by central banks dampened market volatility, the financial system was weakened by the prolonged period of easy money. A frantic search for yield encouraged investors to take greater risks and underwriters to lower lending standards. The international carry trade picked up, as investors piled into higher-yielding debt issued by emerging markets. Ten years after the crisis, the developing world was once again on the brink. When one considers the various ‘transmission mechanisms’ by which ultra-low interest rates affected the economy and financial system it’s easy to understand why Western economies never achieved escape velocity. On the contrary, the unintended consequence of unconventional monetary policies was to reduce the economy’s trend growth rate, thereby lowering the natural rate of interest.

Quick links

Real average weekly earnings are the same today as in November 2005 - the longest period with no earnings growth since the Napoleonic wars.

Interest rates are likely to go on rising…

… and will cause a recession, according to a former Treasury permanent secretary…

… who also says George Osborne says Britain should have joined the euro.

UK two-year gilt yields hit their highest since July 2008 this week.

There is record economic inactivity caused by long term sickness.

Homeowners with a mortgage will vote Labour (44 per cent) not Tory (29 per cent) according to new research.

A former Samsung executive allegedly stole tech to a recreate chip plant in China.

Overseas investors are selling shares in Chinese tech companies.

California has changed its legal definition of infertility to include transgender people, and now requires parents to “affirm” the chosen gender of their children to prove they provide for “the health, safety, and welfare of the child” in custody cases.

616 migrants crossed the Channel last Sunday, a daily record for the year so far.

A Somali rapist who should have been deported has received £80,000 in legal aid.

The suspect detained following the Nottingham attacks is a 31-year-old man from West Africa.

Humza Yousaf is now the first SNP leader in twenty years not to have been arrested.

And the Ashes series has begun.