Inflation, Inflation, Inflation
Graeme Troy FFA
April 2010
Overview
What is inflation/deflation?
Some simple mathematics
Classical Theories
– Inflation falls in a recession
– Printing money causes inflation
– Large budget deficits – Inflation is the ‘easy’ way out
– Risk assets provide good long term inflation protection
The Bank of England – what do they believe?
The General Election
Conclusion
1
What is inflation?
Definition
The rate at which the general level of prices for goods and services is rising, and, subsequently,
purchasing power is falling.
John Maynard Keynes - Economist
By a continuing process of inflation, governments can confiscate, secretly and unobserved, an
important part of the wealth of their citizens.
Bill Vaughan – US Industry Author
Some idea of inflation comes from seeing a youngster get his first job at a salary you dreamed of as
the culmination of your career
Source: http://dictionary.reference.com/browse/inflation, http://thinkexist.com/quotations/inflation/
2
UK Inflation Facts
In 1710, a male teacher’s annual wage was £15.78 – approximately 2.5% annualised
wage inflation for the last 300 years.
In 1906, 1 pint of beer cost two pence (old money). ‘Beer inflation’ has averaged 5.8% in
the last 100 years!
If you put £1 into the Retail Prices Index in June 1947, that would be worth £29.90 today.
RPI inflation has averaged 5.6%pa since 1947.
In 1982, the first Sony CD player retailed for 168,000 Yen, approximately £400 then. Today, a
standard CD player can be bought for £40 : ‘electronic deflation’ of 8% per annum.
Source: http://privatewww.essex.ac.uk/~alan/family/N-Money.html, http://www.igp-web.com/Carlow/wages.htm, ONS Data, http://www.sony.net/Fun/SH/1-20/h5.html
3
What is deflation?
Deflation is a decrease in the general price level of goods and services. It occurs when the annual
inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value
of money – allowing one to buy more goods with the same amount of money
Japan
The only real modern-day example where deflation has had periods of persistency
Source: Wikipedia, Bloomberg.
4
UK Inflation Measures
CPI – The Consumer Price Index
- Probably the most important in terms of economic policy
- BoE charged with targeting 2.0% CPI at a two year time horizon
- If current CPI prints below 1.0% or above 3.0%, the Governor must explain this in writing
to the Chancellor
- Relatively new index (1989)
RPI – The Retail Price Index
- 24% of the index comprises housing: much more volatile than CPI
- More common in pension fund liabilities
- UK government bonds track this index
- Index data back to June 1947
Other indices
- Average Earnings Indices
- Big Mac index (Currency/Inflation trade-off, Economist magazine)
5
Simple Mathematics – Beware ‘Base Effects’!
IndexInflation t 
Index
Inflation rate
Indext
Index0
T0
100
T1
102
2.0%
T2
107
4.9%
T3
108
0.9%
Now suppose a tax change reduces the index by 2% T1 but is reversed T3, with all else unchanged
Index
Inflation rate
T0
100
T1
100
0.0%
T2
104.9
4.9%
T3
108
3.0%
Inflation over the entire period is unchanged, but T1 and T3 rates have been impacted by ‘base effects’
CPI & VAT: In Dec-08 VAT was cut from 17.5% to 15%, and reversed in Jan-10
CPI Index
Inflation rate
Feb-08
106.3
Feb-09
109.6
3.1%
Feb-10
112.9
3.0%
So despite negative base effects due to VAT, inflation remained above target in the UK in 2009
6
Theory 1: Inflation falls in a recession?
7
UK CPI during the recession
The Theory
6
Companies reduce prices to survive
5
People save more, spend less
What has happened
CPI currently > 1% above target
CPI averaged 2.2% in 2009
CPI YoY Inflation
Unemployment – lower demand
4
3
2
1
Petrol prices at all time highs
16 of last 23 prints upward surprise
0
Sep-07
Sep-08
Sep-09
Source: CPI data, Bloomberg
8
Why has UK Inflation Been So ‘Sticky’?
[1] The Currency
The UK is a net importer of manufactured goods
Since 2008, Sterling is down approximately 25% against most of its trading partners
Lagged effects from the currency estimated to be roughly 30 months
[2] Pricing Power / Oligopolies
During a deep recession, smaller companies tend to go bust
Larger companies enter ‘survival mode’
Oligopolies are formed – only a few dominating companies exist (eg UK banking)
Companies then can and will push prices higher
[3] Redistribution of Wealth
The Base Rate fell from 5.5% to 0.5%
Most consumers in the UK have large debts – particularly their mortgages
The costs of servicing existing debt has generally fallen for most people
The majority of people have much more disposable income
This is at the expense of the extra 2.5% of people made unemployed
[4] Oil
Globally, demand for oil has remained resilient – UK is insignificant on a global scale for oil demand
Oil is priced in $
Oil impacts many areas – petrol, public transport, transportation of food, plastics
Source: Currency lagged effects: Michael Saunders, Citigroup economist.
9
Can these pressures fade?
The Currency
Lagged effects from the currency likely to tail off in the next twelve months
More confidence after the General Election?
Pricing Power
As the economy starts to recover, new entrants may join the market
Increased competition should squeeze margins and feed into lower prices
Oil
Over the (very) long term, slow move toward alternative energies
Source: Currency lagged effects: Michael Saunders, Citigroup economist.
10
Theory 2: Printing Money leads to inflation?
11
Images past and present
Germany 1923
Zimbabwe 2008
1923 inflation – prices double every two days
July-08 inflation rate estimated at 231,150,888.87%
Source: http://www.marketoracle.co.uk/Article5713.html, wikipedia
12
The quantity theory of money
MxV=PxQ
M = Quantity of money in circulation
V = Velocity of circulation
P = Price Level associated with transactions
Q = Real Growth expenditures (eg GDP)
V , Q assumed stable. So Increasing M => increasing P?
In the UK the BoE printed £200bn – 15% of GDP, between Mar-09 and Jan-10
The assumption that V is stable is critical
Currently V is broken – banks aren’t lending, consumers are saving more, spending less
If V begins to pick up, it is vital M is reduced or V is kept in check
M can be reduced by selling back the gilts it currently owns, issuing new debt
V can be kept lower via fiscal measures / public spending cuts / higher interest rates
13
Theory 3: Large Budget Deficits => High Inflation?
14
Large Budget Deficit => High inflation?
Early 1970s
Annual budget deficit ran between 5-10% of
GDP
RPI was as high as 27%, consistently above
10%
Mid 1990s
Deficit requirement blew out to 6% of GDP
Economic growth reduced deficit, inflation
stable
BoE independence 1997 – inflation targeting
Now
£1.3 TRILLION outstanding debt by 2015
(2010 Budget)
Political Uncertainty
Source: Datastream.
15
Theory 4: ‘Risk’ assets provide inflation protection
16
Asset Classes – Inflation Protection?
The Classical Interpretation
Equities
–
Revenues and Expenses generally rise in line with inflation
–
As a result so do profits
Property
–
Rents typically reviewed every five years
–
Capital values move with affordability – if profits / incomes move in line with inflation, capital values and rents will
move in similarly
Gold
–
Historically countries used to link their currency to the Gold Standard
–
Central banks can print money, they cannot print gold
–
Limited supply
17
Starting Points Are Critical
2001 to 2009
Since 1986
10
3.5
3
8
Value of £1
Value of £1
2.5
6
4
2
1.5
1
2
0.5
0
Dec-86
Dec-90
Dec-94
RPI
Dec-98
GOLD (GBP)
Dec-02
FTSE A/S
Dec-06
Property
0
Jan-01
Jan-03
RPI
Jan-05
GOLD (GBP)
Jan-07
FTSE A/S
Jan-09
Property
Source: Bloomberg, Gold spot Oz / GBPUSD, Property = IPD Index
18
The Bank of England
19
The BoE Quarterly Inflation Report
CPI projection - constant Base Rate 0.5% and £200bn QE
The BoE
 Target 2% CPI two years ahead
 Fan Chart shows potential outcomes
 Believe key risk is still low inflation
 Suggest Base Rates on hold for long time
The Market
 Little chance of rate hikes this year
 Medium term CPI at 3% - well above BoE
 Election uncertainty
Source: Bank of England February-10 Inflation Report, SWIP assumption CPI = RPI -0.8%
20
Election : Inflation Inflation Inflation?
21
Spending Cuts / Taxes / Growth
Current polls suggest the election outcome is highly uncertain – and so is the economic outlook
The economy is a key focal point – in particular how to deal with the deficit. The major parties agree
more needs to be done to reduce the deficit, but disagree on the method
Public spending cuts can increase unemployment and reduce inflation expectations
Higher taxes on incomes serve to dampen inflation expectations in general
Higher taxes on goods and services (VAT) will increase very short-term inflation, but erode consumer
spending power in the medium-term
All these measures are unpopular – the economic environment will depend on the extent of any
working majority or levels of co-operation in a hung parliament
Economic recovery plays a key role in reducing the deficit - ideally fiscal and spending measures
wouldn’t harm recovery too much
22
CONCLUSION
23
Inflation doesn’t necessarily fall in a recession
Printing money doesn’t necessarily lead to inflation (though it does devalue your currency)
The link between budget deficits and inflation is not clearcut
Asset classes can offer inflation protection over the long term but starting points are crucial
‘Politics’ and ‘Tax’ – may only be worth half a mark in an actuarial exam but their
macroeconomic implications can be critical
24
A Final Thought
Ronald Reagan – President
“Inflation is as violent as a mugger, as frightening as an
armed robber and as deadly as a hitman”
Source: http://thinkexist.com/quotations/inflation/
25