Inflation Fears: Justified or Not?

It has been a turbulent week for the UK stock market as inflation fears spook investors. Concerns regarding inflation have dogged both the US and the UK since the start of the year, with analysts worrying economies may overheat as Covid restrictions are lifted. Consumers with a glut of savings and pent-up demand are forecast to drive prices higher, leading the cost-of-living thinktank the Resolution Foundation to speculate inflation could jump to 4% in the next few months. Former Conservative Home Secretary Ken Clarke has echoed these gloomy predictions, cautioning that there is a big risk of inflation running out of control as the UK’s national debt hits a staggering £2.2 trillion.

This all comes amid the backdrop of the Consumer Price Index (CPI) the UK’s measure of inflation hitting 2.1% in May, the first time it has exceeded the Bank of England’s 2% target in two years. In the US, the situation is even more stark with annual inflation hitting 5%, the highest figure in almost 13 years. The Biden administration has denied that its $1.9tn economic stimulus package has factored into the equation. Nevertheless, rising inflation figures have led to speculation that central banks could raise interest rates with the goal of fighting inflation. Interest rate hikes counteract inflation by increasing the cost of borrowing and incentivising consumers to keep their money in the bank and reap the benefits in interest, at the expense of mortgage holders. Interest has been kept at record 0.1%, and in the short term this remains unlikely to change, but as economic growth forecasts look rosier, pressures on the Bank of England mount.

There is largely a consensus among analysts and pundits that there will be a spike in inflation. However, to what degree and for how long is the issue at hand. A small increase in inflation as world economies open back up is perhaps to be expected. Transient inflation has become the party line for bankers and policy makers who argue short term supply chain issues are the primary cause behind inflation. This neatly dodges the question of whether prices will return to the rate they were prior to the transient inflation or will settle at a new high. Critics point to more endemic and entrenched causes, including the overall growth in the money supply as governments rush to provide safety nets for workers unable to make a living due to the Covid-19 pandemic. Many investors both large and small voted with their wallet by buying commodities and cryptocurrencies as a hedge against inflation. With the volatility in the markets however, this has proven to be a risky choice.

Of course, inflation is not a monolithic force, and it will impact some sectors of the economy more than others. The housing market has seen one of the biggest jumps, as prices increased by 0.8% in June alone, equating to an additional £2500 on the cost of a home according to Rightmove. Despite the pandemic, house prices are growing at the fastest rate in over a decade. Of course, this inflation has been partially induced by the government as stamp duty remains suspended, fuelling a buying frenzy. Yet house prices have risen steadily since the 2008 financial crisis and show no signs of declining in the short term. Many consumers are maxing out the amount they can borrow for a mortgage and could suffer a nasty shock if interest rates were to rise. New house building is also unlikely to catch up to demand anytime soon, meaning price rises are here to stay.

House prices have been joined by notable spikes in building material prices such as timber which rose 8.5%, cement which rose 6.5% and steel and copper which rose a whopping 19.8%, the biggest increase since records began. Again, advocates of the transient inflation explanation would concede these are indeed notable increases, but will they be resolved as supply chains open back up? The answer may be less clear in the case of the UK, as the issue of Brexit also acts as another force driving inflation. Tariffs and additional costs in logistics and paperwork will likely remain a feature of economic life, not only fuelling price rises but keeping them higher long term.

Taken together, it is almost inevitable the short-term spike in inflation will continue. Many of the factors driving it: rising house prices, Brexit, and the growth in the money supply appear to be structural problems as opposed to transient factors. However, the overall impact on consumers may be less drastic than some doom mongers predict. Consumers will likely have to pay more for certain goods, but as economies roar back into action, this may be only a minor problem. It is up to central banks and the treasury to keep a close eye on inflation and to take the necessary measures to curb it should the moment come. As with so much in the Covid era, it is difficult to make concrete predictions. It is a time for steady hands and cool heads to navigate these turbulent economic waters.