The cost of living problem

The biggest economic surprise of 2021 was the resurgence of inflation. This was largely unforeseen at the start of last year and even by the spring was still not expected to become a significant problem. Thus the news that global inflation has hit multi-decade highs is an unwelcome development for households who have to deal with the fact that prices are increasing much more rapidly than wages and central banks who have to decide how to respond.

People aged 30 or younger were not even born the last time European inflation rates reached current levels. Data for December showed the German inflation rate at 5.3% – the highest since 1992, which was also the same year CPI inflation in the UK last exceeded the December reading of 5.4%. We have to cast our minds back to the era of Paul Volcker for the last time the US inflation rate exceeded the 7% rate posted in December (1982, for the record). Those who thought high inflation was a thing of the past have had an uncomfortable awakening in recent months. This is attributable to a combination of global supply bottlenecks in the wake of the pandemic and rising energy prices, both of which are likely to prove temporary (although temporary could mean anything up to two years). Both these elements were encapsulated in the UK data for the transport component of the CPI, which accounted for almost one-third of the annual inflation rate last month. The cost of vehicle purchases rose by 13.9% in the year to December with shortages of key components pushing up prices, whilst fuel costs were up 26.6% on the back of higher oil prices.

UK inflation is set to go higher still when the domestic energy price cap is raised in April. This sets a limit on the maximum amount suppliers can charge customers for each unit of energy consumed. The new cap will be announced in February but is expected to rise by anything between 46% and 56% on the basis of recent trends in wholesale energy prices. Other things being equal this may be enough to push CPI inflation close to 7% in Q2 (chart below). For the record, the BoE’s November forecast pointed to an inflation rate of 4.8% in the second quarter: we can expect a significant upward revision when the new forecast is released next week.

A cost of living “crisis”

All this has given rise to lurid headlines about a “cost of living crisis” and the possibility that many UK households will be pushed into fuel poverty, officially defined as above average fuel costs that push their residual income below the poverty line (a rough rule of thumb adopted in Scotland, Wales and Northern Ireland is that a household suffers from fuel poverty when it spends more than 10 per cent of its income on fuel). The poverty campaigner Jack Monroe made the point in a Tweet that subsequently went viral that the index used in calculating the cost of living “grossly underestimates the real cost of inflation” using the case of rising food prices as an example.

This is both right and wrong. It is right because the CPI is calculated on the basis of average spending shares on particular categories of goods and services, but these differ according to income. Thus if prices rise more quickly for those categories where poorer households have a high spending weight, the average CPI inflation rate will understate their “true” inflation rate. But that was not the case in 2021. I am indebted to the calculations by Chris Giles, which I have attempted to replicate, which demonstrate that price inflation has been higher for households at the upper end of the income scale because their spending basket has shown a faster inflation rate than for those lower down the scale. On my calculations, the inflation rate for households in the lowest income decile was 5.3% in December versus 5.8% for those in the highest decile.

None of this is to say that we can ignore the distributional aspects of inflation. The rise in the energy price cap will almost certainly hit households at the low end of the income scale disproportionally hard. This raises a question of what, if anything, should be done about it? The financial market response is clear – central banks should raise interest rates, and they probably will, but it is unlikely to have any impact on a supply-driven inflation shock. Indeed central bankers find themselves in an impossible situation. If they don’t raise rates at a time when inflation is overshooting target by a wide margin, the future credibility of inflation targeting regimes will be compromised. Against that, if consumers are facing a cost of living crisis in which real income growth is being eroded by exogenous price shocks, monetary tightening is more likely to exacerbate these concerns.

As MPC member Catherine Mann pointed out in a speech last week, the evidence suggests that the recent inflation surge is not based on a narrow range of goods and services but is increasingly looking more broad-based and “has seeped into those [components] that typically are rather stable.” She also pointed out that “Bank research shows inflation expectations tends to be correlated with wage demands, and that items that consumers buy frequently, such as energy, food, and clothing have particular salience for their short-term perceptions of inflation.” A gradual tightening of monetary policy to offset the threat of a wage-price spiral would thus appear to be a prudent move.

Alternative ways to tackle the energy inflation problem

However, it seems clear that monetary policy is only going to be part of the solution in the near-term. One temporary fix to offset the inflationary impact of higher energy prices might be to zero-rate domestic fuel bills for VAT purposes (in the UK it is currently charged at a rate of 5%). It would come as no surprise if this measure were to be announced in the spring budget in March. Another option might be to remove the green levy on household fuel bills, and instead fund them out of general taxation. At present, the Energy Company Obligation (ECO) requires medium and larger energy suppliers to fund the installation of energy efficiency measures, which is charged back to the consumer via their energy bills (primarily electricity). Permanently scrapping the ECO would obviously reduce energy bills, and thus inflation, but would require an increase in taxation elsewhere to fund the shortfall. This problem could be mitigated if the ECO were scrapped for just a year.

One downside with these solutions is that they would benefit both poor and wealthy households and do little to tackle inequality issues. Amongst the alternatives that have been floated are the extension of existing government-funded support to those on means-tested benefits or simply restoring the uplift to Universal Credit that was put in place during the pandemic but taken away in October. Whilst these measures will do nothing to tackle rapid price inflation in other areas they may help to avoid the worst case outcomes in 2022.

Unpleasant choices ahead

Nonetheless, we are likely to be faced with a series of unpleasant choices in the months and years ahead and tinkering with the tax and benefit system is unlikely to resolve them. On the one hand we will likely have to face up to higher taxes as governments attempt to claw back some of the fiscal costs associated with the pandemic. As it is, UK national insurance rates are set to rise in April, at the same time as the energy cap is due to increase. There is also a wider issue associated with the transition to green energy sources. If we are serious as a society about making this transition, there will be a price to pay and consumers will ultimately have to bear it.

Although the pressures on consumer incomes are particularly great at present, and will undoubtedly diminish with time, we may not return to the nirvana of strong income growth and low price inflation anytime soon (at least, not without a recovery in productivity growth to something like pre-2008 rates). The transition to the post-Covid economy may prove to be more painful than anticipated.

"Life was never better than in 1963"

According to the poet Philip Larkin “So life was never better than/In nineteen sixty-three.” It was a year when Martin Luther King delivered his “I have a dream” speech and the year when the Beatles emerged to light the touch paper of the 1960s social revolution. It was also a highly tumultuous year which saw increased American involvement in Vietnam and the assassination of John F. Kennedy. Here in the UK the Profumo Affair caught the public imagination in which a cabinet minister was revealed to be having an affair with a woman who was also involved with a Soviet naval attaché, thus posing a potential national security risk.

The Profumo scandal severely dented public confidence in the government and rumours swirled that senior members of the Royal Family were also caught up in this messy web (sounds familiar). The establishment attempted to close ranks to protect the status quo but something in Britain profoundly changed. The author Pamela Cooper concluded three decades later that “it wouldn't be too much to say that the Profumo scandal was the necessary prelude to the new Toryism, based on meritocracy, which would eventually emerge under Margaret Thatcher.” The historian Richard Davenport-Hines suggested that “authority, however disinterested, well-qualified and experienced, was increasingly greeted with suspicion rather than trust.”

Something similar is stirring today with a “last days of Rome” feeling to the UK public debate. Just as voters in 1963 were increasingly out of tune with politicians who had come of age during the Edwardian era, many people today are expressing outrage as revelations of the government’s behaviour during the pandemic come to light. We can even stretch the parallels a bit further. In 1963 the Conservative government was about to celebrate 12 years in office; was onto its third prime minister (Churchill, Eden and Macmillan), with a fourth (Douglas-Home) set to take over before the year was out, and had engaged in a disastrous international excursion in the form of the Suez Crisis. Fast forward to 2022 and the Conservatives are into their twelfth year in office; have had three prime ministers (Cameron, May and Johnson) and have engaged in a colossal economic gamble in the form of Brexit. History does not repeat itself; it may not even rhyme all that often, but the lessons of the past suggest that this is not going to end well.

The playwright Arthur Miller penned the line “you can quicker get back a million dollars that was stole than a word that you gave away.” This goes to the heart of the government’s troubles: It has lost the trust of the electorate. The same thing happened to John Major’s government following sterling’s departure from the ERM in 1992. Boris Johnson today epitomises that lack of trust. Ironically, the foreign press has always tended to see through him in a way that the British press has not. This week the European press went for the jugular with the Süddeutsche Zeitung suggesting that “Johnson does not govern: He merely plays at being premier.” Jyllands-Posten in Denmark commented that “The garden party is over for Boris Johnson” and pointed out that “it's like reading Animal Farm all over again - Orwell's satirical fable about the Soviet Union under Stalin: all animals are equal, but some are more equal than others.” Perhaps one of the most damning pieces was that published in the New York Times which accused Johnson of something worse than incompetence: A full scale “assault on civil liberties” and an “authoritarian assault so comprehensive that once settled as law, it will prove very tricky to unpick.”

It is ironic that drinks parties during lockdown should provoke such outrage whereas constitutionally outrageous actions such as proroguing parliament or the unlawful fast-tracking of PPE contracts to those with political connections were shrugged off. Nor has the assault on civil liberties outlined by the NYT had much impact. So why now? After all, it is not like Johnson’s actions come as any surprise to those who know him. He is clearly temperamentally unsuited for the highest office. Moreover, governments routinely break their electoral promises. It is not as if this government is any worse than many others on that score.

To get to the heart of the matter we ought to draw a distinction between political sincerity and political accuracy. In this framework, voters identify with politicians who reflect their beliefs (the sincerity effect) and are prepared to overlook factual inaccuracies – beliefs after all cannot be proven. Conversely, politicians who try to make a rational case find it more difficult to get through to voters if there is no meeting of minds. This is just a formal way of saying that people will believe what they want to believe, but it makes sense. Johnson was able to use the Brexit issue to propel himself to the political forefront by speaking to large parts of the electorate which were able to tune out his obvious failings. As the old saying goes, if you can fake sincerity you’ve got it made.

On the question of lockdown parties, Johnson was way out of  tune with the electorate. Voters sincerely believed they were doing the right thing by adhering to the Covid rules and were prepared to make the necessary sacrifices, including not being able to tend to loved ones that were dying. Perhaps if the government had come clean at the start rather than trying to pretend there was nothing to apologise for, it might – just might – have been able to ride this crisis out. It would at least have had a chance of maintaining its political sincerity.

Short of a miraculous turn of events, it is hard to see Johnson coming back from this (which calls into question my forecast that Johnson would still be in office at the end of 2022). As to what happens next, your guess is as good as mine. The so-called independent inquiry into gatherings at Downing Street (terms of reference here) represents an investigation by a civil servant into the actions of people she ultimately reports to. It is compromised before it has begun. Whatever the outcome, there has been a certain amount of jockeying for position in the event that Johnson is forced out. But Chancellor Rishi Sunak, who has long been tipped as a possible successor, is not exactly pulling up trees with his approval ratings. Nor is any other candidate for that matter.

One of the things I wish for 2022 is less focus on politics and more on economics. After all, when the UK is struggling to come to terms with the joint economic impact of the pandemic and Brexit, it is important that the government is focused on its job rather than this side show. Yet for all that domestic politics is increasingly viewed as a soap opera (the media’s obsession with tittle-tattle over the years has not helped), we can take comfort from the fact that things do eventually heal. Events do not come much bigger that the assassination of JFK yet the US did (eventually) move on. Perhaps we should view recent events – both in the UK and elsewhere – as the turbulence that results from the swinging of the political pendulum. But the ride could get wilder still before the turbulence abates.

Outlook 2022: Covid and all that

As we head into the third year of the pandemic, Covid will dominate the headlines again in 2022. There are three possible outcomes: things get worse, they get better or they stay the same (how’s that for insight?). Whilst this may be a statement of the obvious, whichever path we are on will have profound consequences for the economy and outlook for financial markets through the course of 2022 and beyond. Since it is impossible to predict how the disease will evolve, it is worthwhile setting out a few scenarios to assess the range of possibilities.

Case 1: The Covid situation gets worse

In the case where a much more virulent strain emerges, we could quickly find ourselves back in the same situation as 2020 with stringent lockdowns and a big hit to the economy. Unlike 2020, however, we will not be facing a totally new threat; we have experienced Covid waves before and the initial reaction from governments will be to impose fewer restrictions than in March 2020. Accordingly, the initial hit to the economy may be less dramatic. But if the emergent strain proves to be more deadly, there will be a significant hit to confidence and the economy may not rebound quickly as people realise that the pandemic is far from over. In such a case, governments and central banks will be forced to open the taps once again, despite the recent surge in inflation, which will continue to put a floor under markets with equities pushing on to new highs.

Case 2: More of the same

A repeat of the 2021 pattern would see a huge rise in cases at the start of the year as the Omicron variant works its way through, followed by a dip during the spring and summer before another less virulent strain emerges in the autumn. Such an outcome would likely mean an uneven recovery with decent but not stellar growth in the spring and summer and a slowdown over the winter months. Covid restrictions would likely be eased in the first half of the year but, as case numbers mount, continued pressure on health services suggest restrictions will be tightened later in the year which would particularly affect sectors such as hospitality as a quasi-lockdown is implemented. In this environment central banks can be expected to ease back on the monetary throttle to curb inflation in the first half of the year but stand pat in the second half, taking some steam out of markets which push ahead relatively slowly.

Case 3: Omicron proves to be the last hurrah for Covid

In the best case scenario, Omicron is the precursor to the emergence of a much milder form of Covid which becomes an endemic problem rather like flu. Economic growth settles towards trend rates and central banks can afford to be more aggressive in tightening policy. However, high inflation in general and rising energy prices in particular will act as a drag on household incomes, with the result that even in this environment GDP growth remains relatively slow. Against that households may run down some of the excess savings accumulated during the pandemic which will act as a growth support. Inflation is likely to slow as supply issues are largely eliminated by end-year and markets lose momentum in the face of higher interest rates and less dynamic growth. We may even start to hear talk of excess supply and disinflation before the year is out.

Politics and geopolitics are back on the agenda

After two years in which the world has been preoccupied with managing domestic pandemic issues, global geopolitical issues are a matter of urgency for western leaders who are increasingly concerned about a more assertive Russia and China. Russian troops have recently been building up along the Ukrainian border and the US has expressed concerns that this could be a prelude to invasion. We have been here before, of course. Last April, Russia built up troop numbers close to the border only to pull back, so latest moves might simply be another chapter in Vladimir Putin’s power play. But they may not, and in the event of invasion there is very little militarily that the west can do in response. The US has talked of unprecedented sanctions, which the Russians would counter by weaponising gas exports. At a time when European gas supplies are in a parlous state, this could have significant consequences for global energy markets.

President Xi Jinping is the most powerful Chinese leader since Mao and sits at the head of a country determined to regain what it sees as its rightful position at the top table. Unlike in Mao’s era it now has the financial and military clout to back up its ambitions. Recent years have demonstrated that China has no interest in living within the strictures of the western-dominated economic architecture, as its behaviour at COP26 demonstrated, and it continues to make threatening noises regarding Taiwan. Unlike Russia, China has no need to throw its weight around to demonstrate its power. But like Russia, it is increasingly seen as a competitor to western interests and the failed policy in Afghanistan, culminating in the shambolic withdrawal in 2021, will only encourage China to press at the west’s weak spots in 2022 and beyond, leading to even more fraught relations.

Here in Europe, Emmanuel Macron will face his biggest test as he gears up for the French presidential election. Despite poor approval ratings, the polls suggest he will easily make it into the second round where he will face a runoff against either Marine Le Pen or Valérie Pécresse, the centre-right candidate of Les Républicains. The polls suggest he can beat either of them in the second round but the pollsters have been wrong before, notably in the German federal election last year which saw the SPD come from behind to beat the CDU into second place. Still, it would be a surprise if Macron were not re-elected to the Elysée Palace in April.

Another leader under pressure is Boris Johnson who faces mounting discontent amongst his backbench MPs. There has been speculation that a leadership challenge could emerge in 2022 which might happen if a combination of failed pandemic response policies and Brexit pain add to existing woes over political scandals. My own view is that Johnson will end the year in Downing Street. Ditching a third Tory leader in six years, before their term is up, will not play well with an electorate that appears increasingly restive, particularly when there is no obvious candidate to replace Johnson.

Markets: More upside but how much is already priced in?

There are good reasons to expect more upside for equities in 2022, albeit not at anything like the 2021 pace. Economic growth conditions remain favourable and earnings are projected to increase at a decent pace. A high inflation environment in the first half of the year may see a rotation towards inflation trades with gold appearing to be a natural beneficiary along with energy stocks. Up to three Fed interest rate hikes are expected in 2022 which may take the edge off equities, but an absence of Covid-related uncertainty would limit any downside.

Crypto will be one of the fascinating areas to watch this year. Bitcoin hit an all-time high above $67,566 in November and although it has since slipped below $43,500 it is too soon to write off the possibility that it can rally back above previous highs. Although concerns about the energy cost of mining persist, and China has recently cracked down on Bitcoin mining, there has been more widespread retail interest of late. Any wobbles in the equity market could certainly see renewed interest in crypto assets as investors hunt for yield. I maintain that the future of cryptocurrencies will depend on the extent to which central banks enter the field, and with the likes of the Bank of England and ECB looking seriously at the prospect of introducing a central bank digital currency, this may well place a floor under any downside for crypto assets in 2022.

What else?

There are a host of other themes that will move the needle in 2022. Environmental issues are one of them and the debate over how to manage climate change can be expected to make its presence felt. This has traditionally not featured much in near-term economic thinking but maybe 2022 will be the year that we pay more attention to the risks. 2022 is also World Cup year. Assuming it goes ahead, the tournament will start in Qatar in November rather than coinciding with the European summer, which will make things interesting. I am not going to pick a winner but with qualification yet to be completed I can confidently state that Portugal and Italy cannot both qualify.

As 2020 showed, unexpected events are the true enemy of forecasting and whatever happens this year, there will be some unexpected events that come out of left field. As Martin Luther King once remarked, “you don't have to see the whole staircase, just take the first step” which is a good way of saying that so long as our forecasts are not outdated before end-January, we can be reasonably satisfied.

2021: Not great but could have been worse

As 2021 draws to a close, it has felt in many ways like a year in the holding pen as we wait for the pandemic to blow itself out. In the western world we have learned to cope with Covid to some degree and even though life is not back to normal the shock value which accompanied the onset of the disease in early-2020 has been conspicuous by its absence. Unlike 2020 when our year-ahead predictions were blown out of the water, an assessment of the predictions made at the start of the year indicates that GDP growth projections broadly met expectations and equity markets continued to power ahead. It was also the first year in four in which we were spared the spectacle of Donald Trump in the White House, thus taking some heat out of global politics. Not everything went according to plan, of course. One thing that was unforeseen was the huge surge in inflation which necessitated the Bank of England doing the unthinkable by raising interest rates.

Another year dominated by Covid

At the end of 2020 things looked grim on the Covid front. A year ago the world had registered 82 million cases and 1.9 million deaths. They got a lot worse in 2021: There are now 287 million registered cases and 5.4 million deaths. These are clearly an underestimate. Europe and North America together account for more than 50% of all cases and deaths, despite accounting for just 15% of the global population. This is largely attributable to better data recording and testing procedures in the developed world as countries with better developed health systems produce more accurate (or more properly, less inaccurate) data. It is also the result of the wilful underreporting of Chinese figures. According to the WHO, China has recorded just 131,315 cases and 5,699 deaths, of which just 1,045 have occurred since May 2020. The epidemiological profession relies heavily on accurate data to model the incidence of disease and project its progress. Fictional data from the region where the disease was first recorded does nothing to help the rest of the world cope with the pandemic.

One of  the great successes in 2021 was the rollout of the vaccine programme. I must confess in autumn 2020 to being somewhat sceptical that governments would be able to roll out the vaccine as quickly as they promised and that it would take until the second half 2021 before needles would start going into arms in a big way. As of today almost half of the world’s population has been fully vaccinated (two shots) with 23% of Europeans and 20% of Americans having received a third booster dose. The vaccine rollout across the EU started more slowly than perhaps it should have but by end-2021 the proportion of those fully vaccinated has caught up with the UK, whose government trumpeted the speedy rollout of its vaccine programme as one of the benefits of leaving the EU (spoiler alert: it wasn’t).

Economy on track but inflation is not

Largely as a consequence of the vaccine rollout, which reduced the extent to which governments were required to lock down their economies, the global economy has rebounded sharply and appears to have suffered considerably less scarring than I anticipated a year ago. After contracting by 3.1% last year, global GDP is estimated to have grown by 5.9% this year and is projected to grow by 4.9% in 2022. Although global GDP is back above 2019 levels, output in the industrialised world is not quite there yet (although US GDP has been above pre-Covid levels since Q2 2021). Nonetheless, compared to expectations in mid-2020, the recovery has been stronger than anticipated and owes much to the actions of governments and central banks in providing fiscal and monetary support.

One of the unexpected consequences of the post-2020 shock has been the huge surge in global inflation. There were suggestions in the early stages of the pandemic that the hit to the supply side of the economy was such that demand would recover more quickly than supply and that there would be a hit to inflation in the medium term. But this was not the consensus view (nor mine). As recently as April the IMF was reporting that inflation would “remain contained in most countries” and projected US inflation in 2021 at 2.3%: over the first 11 months it has averaged 4.5%, reaching a 39-year high of 6.8% in November. The reawakening of the inflationary threat will prove to be one of the major challenges facing monetary policymakers in 2022. I maintain the view expressed in mid-year that the inflation threat will fade but also maintain the view that higher inflation justifies the “case for taking away some of the extreme monetary easing put in place over the last year” – and the Bank of England has duly obliged, unexpectedly raising Bank Rate by 15bps to 0.25% earlier this month. The Fed is likely to follow suit in 2022.

Markets also performed in line with expectations

As predicted, global equities remain the asset class of choice – there really are few places to invest in this low returns environment that will generate the kind of boost that equities are able to give. The S&P500 surged by 27% in 2021 compared with 15% for the FTSE100 and 16% for the DAX. I suspect further upside is likely in 2022 although not at anything like this pace. Bond yields did edge up a little in 2021 in contrast to expectations, with the US 10-year yield up 59 bps on the year, but given the unanticipated surge in inflation that is not such a bad result.

Brexit not yet done

According to Boris Johnson, Brexit was “done” at the end of 2020 when the UK left the protection of the transition arrangements. But as I have long pointed out, Brexit is a process not a one-off event, and it is not going well. I will come back to this issue in 2022 but suffice to say the economic costs are making their presence felt. UK trade flows remain well below their pre-Covid levels whereas German trade has recovered back above these levels. Meanwhile, the OBR calculates that Brexit will cost 4% of output in the long-run versus a 2% hit due to the pandemic. The resignation of Lord Frost as the UK’s Chief Negotiator of Task Force Europe earlier this month, partly over the handling of Brexit, suggests that the process is not delivering what its most vigorous proponents expected. Nor are voters enamoured of the process with a mounting proportion increasingly viewing the vote as a mistake (chart).

Don’t forget environmental issues

For a brief period last month, environmental issues were all over the news as the climate disaster slowly makes its way up the agenda. But governments have not (yet) stepped up to the challenge. The real action on reducing carbon emissions has to come from China and India, with Asia accounting for over 90% of CO₂ emissions since 1990, but neither of them has a plan in place which will limit the rise in global temperatures over the next decade. Those who have watched the film Don’t Look Up, the current big hit on Netflix, will recognise the unwillingness of governments to deal with issues which clash with their electoral priorities. It is not just Asia which has to do more to deal with climate issues: Europe and the US will also need to act, largely because they are in a better financial position to do so. Perhaps what 2021 demonstrated (yet again) is that whilst we all like the idea of saving the planet, we are unwilling to pay the price – both financially and in terms of lifestyle change – to make it happen.

It has not been a great year by any means, but if you are reading this, at least you got through. A Happy New Year to you all and here is wishing a healthy, happy and prosperous 2022