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UK inflation has hit a fresh 40-year high, with the Consumer Price Index (CPI) reaching 9.4% in the 12 months to June. It’s time to remind ourselves of what’s causing these price rises and what could happen next.  

Early signs were there… 

Concurrent with the latest data, you’ll have no doubt seen many blogs and news articles speculating about how high inflation could go, and its impact on our everyday lives. It may be hard to remember, but prior to and during the Covid pandemic economic commentators were speculating around a very different scenario.  

The argument then was the West was undergoing ‘Japanification’; the inability to generate even a low level of inflation. Inflation was, according to this thesis, nowhere to be seen on the horizon.  

We did not agree, as we wrote in 2020. We thought then, as now, that inflation definitely had a future in western democratic economies. We reiterated this view in May 2021, noting that inflation was finding its feet. We specifically referenced the onset of unusually high inflation in durable goods prices (e.g. long-lasting products such as household items). Our non-consensus views on inflation have played out, with massive spikes in these goods prices driving core-CPI higher

Food and energy prices jumped too, further supercharged by the supply disruption caused by Russia’s invasion of Ukraine. Now, in mid-2022, the opinion-pendulum has swung completely in the other direction, with the economic commentariat no longer arguing for ‘Japanifaction’ but ‘stagflation’, where inflation stays high even without much economic growth.   

The real impact of the Covid shutdowns 

From insisting modern developed economies cannot generate any inflation to the view that even weak growth will cause excessive inflation; that’s quite an about-face. So, why the big turnaround in analysts’ opinions?  

The unusually high inflation currently being experienced globally can be partially traced to the fiscal policies adopted during the Covid shutdowns. These were designed to maintain income levels when prohibitions on mobility prevented many from working. The UK was perhaps the most extreme example of this, with 12 million people on furlough payments at some point.  

An often-overlooked fact is that this income backstop provided by the government prevented a massive cost of unemployment at the time; the economic and personal cost of which would have been very significant. But while that was avoided, a cost could not be avoided altogether; the cost we are now experiencing as high inflation.  

Because incomes were protected at their original levels, and because the supply of goods and services have yet to return to their original levels, the economy has been in demand-supply imbalance. This can be best seen in goods price inflation in Chart 1 below:  

Chart 1: UK CPI for all goods, % year-on-year 

Paying for the Ukraine war 

Another major contributor to today’s inflation is the fact that food and energy prices have been put under further pressure by the terrible events in Ukraine through the interruption of globalised supply chains. You can see how this has impacted prices in the UK, especially energy, in Chart 2 below:  

Chart 2: UK CPI food & drink and energy, % year-on-year 

Without doubt, this is a cost of the conflict shared by the world. Putting the horrors of war to one side, it remains important to remember that part of the inflation we are experiencing is a direct cost of this conflict.  

When will price rises subside? 

In the case of the global pandemic, there is a sense in which all stakeholders in our economy need to acknowledge the lesser cost they are now paying compared to what might have been.  

We should accept and celebrate the success of vaccine rollouts and government policy that prevented more damaging costs. Some try to argue that high inflation is here for the long term, with the stagflation lobby advising it’s a part of our economic furniture now. We disagree. 

Chart 3 shows how the bond market agrees with the Bank of England (and Nutmeg) that this passage of price pressure is temporary. The blue line in the chart represents the bond markets best guess at the average inflation rate prevailing over the next ten years. It’s a measure that moves around with market psychology. But the important take-away here is that current high inflation is not expected to persist. 

Chart 3: UK CPI vs bond market expectations vs BoE inflation forecast, % year-on-year 

From a global level, one early indication that the pressure is abating is this measure of global supply compiled by the New York Federal Reserve. The past 18 months have been shaped by the clash of high spending power with greatly diminished production capability due to supply constraints. Chart 4 shows a welcome tapering of this pressure as production levels normalise.   

Chart 4: Global Supply Chain Pressure Index  

What this all means for investors  

The Nutmeg investment team continues to monitor a wide range of data and information to assess the outlook for economies and financial markets. There are good reasons to be positive that the economic recovery continues to maintain traction. But there are risks surrounding near-term real income shocks and the stepped-up pace of central bank policy tightening which will both lean against the positives.   

Furthermore, deteriorating risk-scenarios around the Ukraine conflict and its global impact have come to warrant greater attention. For these reasons we maintain a neutral level of risky asset exposure across the different fully managed portfolio risk band. We don’t place stagflation or persistently high inflation central to our outlook. And, as usual, we retain the flexibility to respond to events as they unfold.  

Risk warning  

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and forecasts are not reliable indicators of future performance.