24/08/2023 Inflation has been on a wild ride. For the first time in decades
the headline rate in the US, UK and Europe has been in the region of 10% but it is now
heading lower. Does this mean the inflation scare is over? 
The chart above from the
latest
Bank of
England Monetary Policy Report would suggest the heady heights of inflation are behind us.
Part of the reason for this is mathematical, in that prices must keep accelerating higher in
order to maintain a high rate of change. Momentum rarely keeps up at such a high pace.
Eventually it slows down. Another reason is what economists like to call “base effects”.
This means that the baseline for the comparison changes. Just over a year ago we had a big
jump in prices after war broke out in Ukraine and commodities in particular were in short
supply. That bumps up the baseline so that twelve months later, the shift isn’t so large.
You can see from the charts that the contribution of energy prices to CPI has eased off
significantly, as represented by the orange bars. In fact, when it comes to the US and the
Euro Area, the orange bar is now negative, meaning energy prices are now having a
disinflationary impact! But this isn’t just a story about energy. You can see from the
charts that a steady positive contribution to inflation rates comes from the gold bars,
which represent services inflation. That’s things like paying for healthcare, going to the
hairdresser or enjoying some hospitality in a hotel. And all of those were things we
couldn’t do during the pandemic. The splurge on services has been described by some,
including
BlackRock
, as
“revenge spending”. We were denied the chance to do all of these activities and now that the
world is open once again, we are persistently going out and spending on them as hard as we
can. This effect may eventually peter out
but it’s possible that the pandemic has changed the balance of our spending for good.
It’s surprising that we are even
surprised by such big changes in inflation. A war and a pandemic are just the kinds of
unusual events that throw economies into a state of flux. So why all the focus on inflation,
given it’s likely to remain volatile until the economy settles down into its post-pandemic
pattern? The obsession with inflation comes from the accompanying implication that central
banks have finished their interest rate hiking cycles. And that would mean a moment to calm
down and assume liquidity conditions will no longer tighten any further. Then everyone can
breathe a sigh of relief and hope that there won’t be any more banking wobbles,
cryptocurrency meltdowns or bond market debacles like the one in Gilts last autumn. This
would be a mistaken assumption. Just because a central bank stops increasing interest rates
doesn’t mean it suddenly starts to cut them. Inflation has likely peaked but that doesn’t
mean it will merrily settle back down to its pre-pandemic average of around 2%. The shifts
taking place in the economy take years, if not decades, to settle down. People are
re-evaluating their lives. They’re moving country, changing job, switching to a new house
with more space. Working from home has ripped up the rule book for how we can live. A more
virtual world means one where Pret a Manger don’t need an outlet every 100 metres, which is
how it used to feel in the City of London during a busy weekday lunchtime. Pret a Manger
said
in September
2021 that they planned to double in size in five years by focusing on opening new stores in
suburban areas and motorway service stations. In the meantime, inflation will remain higher
than it was before the pandemic. It is unlikely to head back into double digits, absent
another shock, and in that sense we have seen the peak. But all of the inefficiencies in the
system as we adjust to our new way of life means that the new plateau will be higher than in
the past. And that means interest rates will also be higher than they were before the
pandemic. Tighter monetary conditions seem to be here to stay. 
Helen Thomas
CEO of BlondeMoney
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