The cure for inflation, says Steve Snowden, bond fund manager at Artemis, is inflation.
His view is that prices rising at a materially faster rate than wages eventually causes the level of aggregate demand in the economy to fall, that is, the available supply of goods and services exceeds the demand for goods and services in the economy.
Faced with such a scenario, companies can either cut prices in order to stimulate demand, which reduces the level of inflation in the economy, or cut the supply of goods and services to bring it into equilibrium with the level of demand.
The risk associated with the former is that many companies, being unable to compete on price, will go bust, increasing the chances of a recession.
The risk associated with the latter is that the reduction in supply leads to unemployment rising, and ferments a recession.
But in either case, inflation comes down.
It is for this reason that Snowden says interest rates in the UK will not rise to the heights markets expect, as he feels the present very high inflation rate will drive demand sufficiently that central banks, including the Bank of England, will not need to raise rates by as much as the market is presently expecting.
Allison Boxer, US economist at Pimco, says some data in the US is already showing some signs of this, with stock levels rising. She adds that inflation expectations, that is, the level at which consumers expect inflation to be in future, are also much lower than the actual level in the US right now.
Central banks, by putting interest rates up, are attempting to force a combination of the above two outcomes.
Higher rates make debt more expensive, and saving relatively more attractive. Debt being more expensive means investors must deploy more of their capital to repayments, and so have less to spend on other things, bringing demand down closer to supply.
Higher debt costs also make it relatively less attractive for companies to increase production, forcing supply down.
Dario Perkins, managing director of global macro at TS Lombard, says one of the caveats to this line of thought is that in the 1970s in the UK there were several recessions that were caused by high inflation, but inflation did not actually fall.
This may have been because the inflation was, to a large extent, imported from abroad, initially via higher oil prices, and such price movements are largely exogenous to the performance of the domestic economy, though demand for petrol would fall a little amid higher prices.
Wage growth
The other factor that could cause inflation to persist is wages remaining high, that is, the supply of available workers remaining below the level of demand for workers.
A combination of Britain’s exit from the EU potentially reducing the supply of migrant workers, the pandemic changing working habits, and ageing populations in much of the developed world has reduced the supply of labour.
