These articles have been published in the Economist, Standpoint Magazine, Financial Times, MoneyWeek, the Times Literary Supplement, New York Observer and more
Since the global financial crisis, the UK and other advanced economies have experienced a prolonged period of low inflation. But following the Brexit vote the wind of change can be felt, as the prices of food and clothing have risen.
Once a month, the Office for National Statistics (ONS) calculates the Consumer Prices Index (CPI) inflation figure. For this purpose, it looks at a ‘basket’ of goods and services typically bought by UK households. This is used as a measure of inflation. Peeking inside that basket, we can see, for instance, that over the past year tea bags have risen in price from £1.93 to £1.98 per 250g on average, while tomatoes have risen from £2.01 to £2.26 per kilogram.
In May inflation stood at 2.9 per cent, its highest level since April 2012, up from 2.7 per cent in April and well above the Bank of England’s 2 per cent target. Consequently, the Bank of England warned that inflation would peak at just below 3 per cent this year. It also warned that 2017 would be ‘a more challenging time for British households’, as inflation is rising and wage increases are failing to keep pace, which will squeeze consumers’ purchasing power. Earnings growth averaged just 2.1 per cent year on year in May.
Several factors have driven this inflation. Most notably, there was a big fall in the value of the pound after the Brexit vote, so the price of imports has gone up in sterling terms. Globally, there have been huge swings in oil prices, which affect the prices of items from airfares to plastics.
However, while inflation is expected to rise and peak at just below 3 per cent in the fourth quarter of 2017, according to the Bank of England, powerful deflationary – or disinflationary – forces are also at work. They include demographic changes: the ageing of populations in the West that will progressively spend less. Debt, which is now 30 per cent higher globally than it was in 2007, is another potentially deflationary factor. The internet, which provides price transparency by facilitating comparisons, helps keep prices down too.
Until recently, little attention has been paid to the effect on prices of a population comprising an increasing proportion of elderly people. However, Japan, where an estimated 26 per cent of the population is aged 65 or above, shows what may be in store for the UK. In the UK about 18 per cent of the population are currently aged 65 or older and a demographic pyramid similar to the one in Japan is on the horizon. Life expectancy continues to rise, while the state pension age has hardly increased and birth rates are falling. This means the working portion of the population is declining, which leads to changes in the consumption and saving behaviour of the overall population.
In January 2017 the European Central Bank published evidence that an ageing population has indeed been one of the key drivers behind low inflation in recent decades. This view assumes that older people consume fewer goods and services, and therefore depress demand. Typically, young people tend to spend more on housing, transportation, digital communication and education, while old people tend to spend more on medical care and travel, according to an IMF working paper from 2014.
‘It’s only relatively recently that economists have formed that orthodoxy,’ says Ed Smith, an asset allocation strategist at Rathbones. He adds that in the middle of the 20th century, an ageing population was associated with high inflation. The argument for inflation is that as people grow older they require more intensive health services, and if there are fewer people working in healthcare, that can create inflation in the sector.
But Smith argues that the debate has possibly more to do with shifts in the cohort of those aged 40-65. ‘They are reasonably high earners and save a large chunk, so they drive down demand and therefore create deflation. And that tendency to save is exacerbated by longer life expectancy. If this cohort is about to shrink, which it is in western Europe, then the outlook for [their impact on] inflation isn’t so clear cut,’ he says. The population is still ageing, but the saving cohort – which is the deflationary factor – is now shrinking.
Debt can also drive deflation. That’s because companies must pay interest on loans instead of investing in new products and services or in more staff and capacity, all of which could boost growth and therefore inflation, argues Russ Mould, investment director at AJ Bell. ‘In addition, borrowers may find themselves selling off their goods in a hurry if they are struggling to repay their loans, and to do that they will probably have to cut their prices.’
Keynesian economists might argue that judicious borrowing by governments can promote growth and stave off deflation if those governments invest counter-cyclically and spend during a recession. The theory is that growth will boost tax revenues and balance the books.
‘People talk about debt being deflationary, but really it’s about your debt servicing cost,’ Smith counters. Since the financial crisis, debt is substantially higher, but debt servicing costs are lower, due to the collapse in interest rates. He adds: ‘I don’t really see high levels of debt translating into deflation, because the debt servicing cost isn’t eating into income enough to depress demand.’ He adds that if other factors drive inflation to zero or negative, a large pile of debt makes the problem a whole lot worse, but debt’s exacerbation of deflation does not mean it is causing deflation in the first place.
The internet is now an important deflationary influence because it creates transparency and enables people to compare prices. Where customers can easily compare prices, ‘it is easier for them to pick the cheapest option or at least the one they feel provides the best value for money’, says Mould. ‘In a similar vein, it enables companies to create lower-cost business models and therefore charge less for products and services – think books or music.’
As the internet can be accessed from anywhere in the world, globalisation puts downward price pressure on many products. Anyone can find out who the cheapest provider of a product is, and people are no longer limited to buying locally.
James Henderson, who manages the Lowland trust, says: ‘I can’t see the UK inflation rate moving out of sync with rates in other countries unless tariffs are brought in [because of Brexit]. If we remain an open economy, it should stay similar to inflation rates in other countries.’
The smartphone provides a good illustration of how a new technology can change consumption patterns. Typically the modern consumer has replaced their camera, music player and diary with a single device – a smartphone.
It’s a similar story with films. Only 10 years ago, people would rent one DVD from Blockbuster for about £4 for four days – and pay a fine if they forgot to return it on time. Today, they pay £5.99 a month to watch an unlimited number of films on Netflix.
Statisticians find it a challenge to keep up with the drastic changes in the prices of goods and services brought about by technological innovation. ONS statisticians have to produce an inflation report once a month, and it can be argued that they are unable to produce an exhaustive analysis on their limited budget. James Carrick, an economist at Legal & General, says it would ‘take a year to produce a proper report that would incorporate all the market changes that occur when new products come out’.
The ONS inflation report is paid for by taxpayers, who don’t want money spent on what they deem to be bureaucracy, so funding restrictions mean inflation reports lag abrupt price changes brought about by technological innovation.
This, says Carrick, ‘partly explains the productivity puzzle: people wondering why the economy isn’t growing, while unemployment is low, and why living standards are said to be stagnating while there are so many innovations’. He adds: ‘Inflation is a complicated beast, and there is limited time and money [to monitor it properly] .’
That’s why in the 1980s, statisticians were under-recording service industry data in their inflation reports; they were still primarily focusing on measuring manufacturing output. In the 1990s they were not accounting for rapid innovations in computer hardware until the US Federal Reserve chairman at the time, Alan Greenspan, argued that US inflation was overestimated by 0.5-1.5 per cent as a result of this omission. The Boskin Commission confirmed an upward bias to inflation. Consequently, the inflation report was adjusted to account for the fact that $1,000 bought a better computer every year, which meant that the price of an equivalent computer over time was effectively falling by around 30 per cent a year. Statisticians did eventually adjust their figures to take account of advances in computer technology, and the CPI was modified accordingly.
Carrick says that, similarly, cloud computing is not properly accounted for in current inflation reports. It can be argued that if we are on the cusp of another technological revolution, as some claim, businesses might be forced to innovate more to keep up with the competition. Technological innovation could then be inflationary if it stimulates demand for new products. However, Smith says: ‘Overall, technology leads to cheaper goods, so the dominant effect tends to be disinflation.’
This summer, UK citizens will be able to travel in Europe without being charged extra for using their phone abroad – they will effectively get a price cut on their data. But will this be captured in inflation data? Probably not.
It’s this kind of development that leads Carrick to argue that ‘inflation is overestimated, living standards underestimated and GDP not properly measured’. He concludes: ‘If the world never changed, it would be easy to measure prices, but when the world changes, it gets very hard.’