Issue 259: 20 12 10: Inflation

10 December 2020

The Inflation Enthusiasm Curb

A potential economic nemesis.

By Frank O’Nomics

We are all doing it. The roll out of a covid vaccine, it is hoped, will make 2020 just seem like a bad dream. The prospect of recovering lost growth, with a backdrop of exceptionally low interest rates, has set all markets on a bull run and woe-betide you if you don’t join in. So what could possibly go wrong? One of the real dangers it seems is inflation. For such a long time the bigger risk has been deflation, but evidence is growing that, not only are price indices turning up, but also, when baskets are properly adjusted, they may already be much higher than we realise, with both social and market consequences.

Why might this be the case? The answer comes in the way that covid-19 has changed consumer expenditure patterns, leading to an adjustment in prices and leaving a significant bias in the way that inflation is measured. While we are all spending a lot less on transport, hotels, restaurants and recreation, the prices of these goods and services are moving very little. The areas where everyone has increased their spending –  food, drink and other consumer goods – have seen greater price rises. In a perfect world the basket of goods used to measure inflation would adjust to reflect this shift in spending patterns, but this only happens once a year. The last change in CPI basket weightings in the UK happened on 25th March, just as we were embarking upon this major shift in spending patterns. When we reweight next year there is a danger that we see a discrete shift in the level of inflation.

How bad could it be? This is very hard to answer, but a recent study* by Alberto Cavallo of the National Bureau of Economic Research in the US gives us some idea. He looked at the official US CPI index for May of this year of 0.13%, and then recalculated it based on revised weightings that reflected the change in spending patterns, which gave an answer of 0.95%. Such a difference may not seem of concern but it is significant, and the more disturbing factor was that it is on a clear upward trend. What makes this worse is that, not surprisingly, the covid CPI rate for those on a lower income, who by definition spend a greater proportion of their earnings on food, was even higher at 1.12% (it was only 0.57% for higher earners). Of the 16 other countries that he looked at, 10 of them were experiencing the same bias in inflation measurement.

Back in the early summer the calculation bias for the UK was relatively modest (0.67% vs. an official 0.59%), but there is good reason to be concerned that this has shifted significantly in the interim period, and that it is likely to get worse. A cynic might just point to the healthy bounce in supermarket profits, but it goes beyond the end of discounting. There has been a marked reversal in the globalisation effects that had, for so long, been keeping price levels at a low level. People have been forced to buy local and to pay up for the privilege. One might expect this effect to dissipate as we return to some normality, but once the inflation genie is out of its bottle it is hard to put back. Further, for the UK, even with a Brexit deal, the de-globalisation effects could last longer and be more pronounced than elsewhere.

Why should we worry about this?  Surely the return of inflation is exactly what had been sought when interest rates were cut and quantitative easing introduced. The big problem comes if inflation prompts a reversal of that loose monetary policy at a time when the economy is very vulnerable. Rishi Sunak has already warned that the UK’s debt was “unaffordable” and, with borrowing set to double, this becomes a big problem if the cost of servicing the debt becomes more expensive. It also has implications for fiscal policy. If inflation is running higher than reported the levels of universal credit and the minimum wage will not be keeping pace with the true cost of living.

While inflation is becoming a greater potential problem, there is no doubt that we are starting from a very low base. A marked further deterioration will need to occur to unsettle most of the stock market bulls. However, it is important to be aware of the risk. Some investors are already taking steps to mitigate some of this risk, with some very large flows into “Tips” (US Treasury Inflation Protected Securities). That kind of insurance could prove to be a wise move. For the policy makers, however, it is the social consequences that may need to be mitigated.


Working Paper 27352 (

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