Inflation in the UK has remained at 3 per cent in October, a percentage point higher than the Bank of England’s target rate.
Inflation has largely been the result of rising import prices, owing to the pound’s continued weakness on currency markets. As the value of the pound goes down, the price of imports – either whole or inputs for other goods – gets more expensive.
However, such import-inflation is likely to be temporary. Unless the price of sterling takes a major hit again, or the currency of close trading partners such as the EU soars again, such import inflation-induced price rises are unlikely to continue.
Where does that leave inflation for the long-term in the UK? In a new study, Under Pressure? What Drives Inflation and where it’s Heading, Rathbone Investment Management looks at some of the larger trends and structural forces likely to determine the UK’s inflation rate in the future.
The assumption – usually formed by looking at the experience of Japan – has been that an ageing population will have a deflationary effect on an economy. Rathbone’s study challenges this. While an ageing population has the potential for both inflationary and deflationary affects, in the UK, it argues, it is set to experience inflation as its population gets older.
Since the 1960s, the number of non-workers relative to workers has been shrinking. This has had a deflationary impact on the UK’s economy, as ‘the number of producers has grown more quickly than the number of consumers.’ This, however, is now reversing: ‘ageing has just entered a new era,’ says Rathbone. The number of workers relative to non-workers reached its peak around a decade ago; ‘from now on the proportion of pensioners is set to grow more quickly than those of working age.’
This, Rathbone argues, will be inflationary, as there will be an ‘increasing number of non-workers competing for the goods and services produced by relatively fewer workers.’ This will give workers greater bargaining power and in theory push up their wages, potentially beyond increases in the amount they are producing.
The UK has also seen the main ‘deflationary demographic’, those in middle age, peak. ‘In the UK,’ the paper notes, ‘the proportion of 30- to 64-year-olds in the population peaked in 2005.’ People in middle age, it is assumed, save more and spend less, causing a deflationary effect. However, savings are delayed spending. As middle-aged people move into retirement, they will start to spend those savings, with an inflationary effect on the economy.
The inflation caused by this increased spending could also be amplified according to where in the economy the money is spent. The assumption is that older age groups spend money on labour-intensive industries in the service sector, ranging from holidays to social care. With a shrinking number of workers to non-workers, increased demand in labour-intensive industries would also be inflationary.
In the UK, Rathbone concludes, ‘ageing is on the cusp of becoming inflationary.’ From the 1970s to the 2000s, the UK (and other advanced economies) saw ‘ deflation as a result of age demographics growing the proportion of 35- to 64-year-olds.’ Now, in the UK, ‘the proportion of that cohort has peaked; from the age of 65, the average person carries inflationary pressures.’
Globalisation – inflationary or deflationary?
Since the 1990s, the world has seen increased international trade, the reduction of trade barriers, the creation of global supply chains and the integration of former Communist states and developing world workers into the global workforce. Globalisation, in other words. All of this has worked to make goods cheaper. ‘Between 1998 and 2006, goods inflation (excluding energy and food) averaged around -1.5 per cent a year in the UK,’ Rathbone notes. Globalisation, then, is said to be deflationary.
However, that’s not the whole story. While globalisation has meant cheaper goods, it has also meant increased economic demand and prosperity. Whether its industrial inputs or increasingly prosperous citizens of China, India and elsewhere, globalisation has pushed up demand, and therefore prices, in other parts of the economy.
In particular, China’s rapid development, the report notes, ‘led to a soaring demand for commodities and agricultural products. During 2004 to 2006 the region accounted for 40 per cent of the growth in global demand for oil and more than 70 per cent of the global growth in copper and zinc.’ While commodity prices have been in the doldrums for the past few years, in the 2000s prices soared, making their presence felt in advanced economies in the form of rising utility bills.
When it comes to the increasingly rich members of emerging markets, Rathbone notes: ‘as globalisation brought hundreds of millions of citizens in emerging markets into the middle classes, their incomes compete for many of the same goods and services that fill advanced economies’ inflation baskets.’
Rather than being deflationary, on balance, globalisation’s impact on inflation may have been closer to neutral. According to a study by Federal Reserve Board of Governors, deflationary pressure from cheaper manufacturers in the 1990s and 2000s was offset by commodity price increases, leading to a net effect close to zero.
Likewise, a study by the OECD found that the net effect of globalisation in both the US and the eurozone was zero to 0.25 per cent. ‘Toys and gadgets may be cheaper,’ Rathbone notes, ‘but that has been at least partially offset by the rising cost of food, fuel and building materials.’
What does that mean for the future of inflation? There a number of trends. First of all, according to many, we have reached ‘peak globalisation.’ Trade growth now barely keeps pace with global GDP growth. Exports as a percentage of GDP are no higher than they were a decade ago, while wage differentials between advanced and emerging markets have narrowed, reducing the incentive for offshoring manufacturing.
Does this mean we are in for a bout of inflation? Perhaps not. While globalisation reduced prices for imported goods, when it comes to the US at least, the price of domestically produced goods also fell. As the Financial Times journalist Matthew C. Klein has noted, ‘In America, the price index for all durables has dropped much more than the price index for imported durable goods since 1990. That suggests technological innovation has been more important than import competition.’ There’s no reason to believe domestically produced goods, or goods produced in other high-waged economies, won’t continue to trend down in prices.
At the same time, the inflationary pressures of the 1990s-2008 period of globalisation are likely to be less pronounced, according to Rathbone. The next phase of globalisation, it argues, will be focused on services, which come with less inflationary side-effects.
‘Tradeable services (such as computer programming, design, accountancy and call centres) are far less capital intensive than manufactures,’ Rathbone comments. ‘They do not require such large investments in structures, equipment and supporting infrastructure to get them up and running. They do not need kilometre-long factories, expensive precision instruments or transport to get their goods to market.’
Therefore, ‘the offshoring of services to emerging markets would be unlikely to exert the same upward pressure on commodity prices.’ However, while manufacturing demand for commodities may not grow at such a fast rate anymore, demand for goods from the increasingly prosperous citizens of the developing world will continue to rise.
Where will inflation go from here?
It should go without saying that how each the factors involved in these two trends will play out is hard to predict. While globalisation has not been as deflationary as often thought, it has, at most, had a net effect of zero. The future of globalisation, however, may be more deflationary than the past period. But, globalisation, often treated as an inevitability, is also a political choice – as recent politics events show, appetite for further integration of the world’s economies may be waning, at least in richer countries.
And, as governor Mark Carney once noted, if globalisation is deflationary, deglobalisation is likely to be inflationary. At the same time, the demographics of advanced economies, UK included, look set to produce at least moderate inflationary pressure.
Rathbone, however, believes that the most likely scenario will be inflation that ‘remains well anchored and under control.’ With a 65 per cent probability rating, it argues that inflation will remain between 1.5 and 2.5 per cent.
What does that mean for investors? In such a scenario, Rathbone suggests keeping a balanced, multi-asset portfolio with equities at its core.
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