How will spare capacity restrain inflation?
This week’s meeting of the US central bank, the Federal Reserve, was as quiet as expected. Jerome Powell and his colleagues are leaving the door open to further decision and actions, depending on how the economy performs in the coming year. The Fed is not alone, most central banks are watching and waiting.
This gives the markets the opportunity to assess what is happening to some key aspects of the economy, especially growth and inflation, which in turn will influence tax revenues and public spending. In the past week, two announcements in the UK set the tramlines for investors to consider into 2021.
The first concerned inflation in the UK. ONS data appeared satisfactory at face value – the consumer prices index (CPI) only rose by 0.6% in the year to December, up from 0.3% in November. Of course such historically low figures reflect the impact of the pandemic, for example clothing and footwear firms have been forced to slash prices amidst the second lockdown.
Looking ahead, most forecasts suggest that inflation will rise back towards the Bank’s target. Various factors are at work; one is base effects – for example oil prices are currently running above $50 per barrel versus negative figures seen for a short while in April 2020 and an average of about $40 for most of last summer and autumn. On top of commodity prices, global shipping costs have increased. Higher prices should also appear in the hospitality and recreation sectors in April, when VAT will return to 20% from its current 5% rate.
If we look at some of the blue-chip forecasters, the range of estimates made by the OBR, the IMF and NIESR is 1.5-2.0% pa in 2021. Some forecasters are rather downbeat on a longer-term view. For example, the OBR forecasts inflation to remain below the Bank’s 2% target rate until at least 2025. Others are rather more concerned, reflecting such issues as the impact of Brexit trade disruption on the prices of imported goods, especially foodstuffs, or the effects of very rapid money supply growth. Households have considerable savings which they can draw upon, if some of the expectations of a surge in consumer confidence prove correct. The withdrawal of capacity in areas such as holidays and air travel could allow some companies to regain pricing power, if and when vaccinations allow much greater travel.
Clearly a major factor affecting future inflation will be the degree of spare capacity in the economy. Last week’s labour market report is a good way of analysing the situation. Unemployment in the UK has reached 5%, the highest level since 2015. The sad fact that 1.7 million people are out of work does not give the full picture; at the end of December almost 4 million people or 13% of the overall workforce were reported to be on furlough. Mr Sunak’s decisions in the March Budget about whether to extend the furlough scheme, and then the pace of tapering versus the revival of commercial activity, are clearly of great importance.
Here again there is a range of forecasts. The OBR estimates that the jobless rate will peak at about 7.5% in the middle of 2021, the more upbeat economists see a figure as low as 6.5% whilst the downbeat ones warn of a peak of 8-9%. There are many moving parts, including the extent of the disruption to Brexit trade, evidence that the labour force has declined because many EU workers have returned to the Continent, the success of the vaccination programmes, the extent of mutations in the virus, or changes in consumer spending patterns. The longer-term picture is whether the UK economy returns to its pre-virus level of GDP by the end of 2022 or the end of 2023, with a further question about the extent of the economic scarring from the pandemic on the long-term or trend rate of growth.
The value of an economic forecast is not in a point figure, or even a range of numbers, but the underlying analysis, understanding the drivers and moving parts, the risks and sensitivities. Looking ahead, UK inflation is set to rise into 2021, but the extent looks likely to depend on the amount of spare capacity and especially the shifts in consumer confidence and spending patterns as the pandemic begins to end.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making