Inflation is a phenomenon of great importance to investors. It is subject to intense scrutiny but is not well understood. Sandy McGregor, portfolio manager at Allan Gray offers his perspective on what is a truly complex issue.
The South African Reserve Bank has responded to lower-than-expected inflation with caution. Its mandate involves both price and financial stability. There are good reasons why interest rates should be kept unchanged until there is more certainty as to how the government’s fiscal challenges are to be resolved.
However, there are also strong arguments that, given current inflationary trends, interest rates are too high.
McGregor discusses the surprising reasons why South Africa’s inflation has been persistently higher than in other market economies by looking at the history of inflation.
In 1924 Alfred Marshall died. Marshall was the pre-eminent economist of his time and his passing prompted John Maynard Keynes to write a memorable biographical essay which was published in the Economic Journal. Many regard this as the best piece Keynes ever wrote. In it he mused about economics as an intellectual discipline, saying that it is an easy subject at which few excel.
He explained this paradox as being a consequence of the broad diversity and complexity of factors which determine economic outcomes. No one has the detailed knowledge required to fully understand what is going on.
Many contemporary economists retreat into formulating complex mathematical models to achieve this goal.
However, the outcome of these endeavours does not inspire confidence. Inevitably the quality of data used is poor, failing to reflect the subtle complexity of reality.
Accordingly, there is a tendency to discuss the economy assuming a knowledge which we do not have.
Since an admission of ignorance offers little of value to market participants or to academics whose careers depend on formulating new certainties, we discuss economics in terms of widely accepted paradigms, which are seldom questioned.
Inflation and interest rates are among the phenomena that receive intense scrutiny yet are poorly understood.
Perhaps the best way to escape the tyranny of the prevailing consensus is to study economic history, from which one can gain some insights on how we got to where we are now and on how the world has worked in practice.
However, the dilemma articulated by Keynes remains. It applies not only to economists, but also to investors and those who determine public policy.
Price stability as the norm
With the exception of some grossly mismanaged economies such as Venezuela and Zimbabwe, currently a feature of the global economy is widespread price stability.
Despite this, those whose formative years were in a period of high inflation never escape the fear that inflation will return, destroying their savings and living standards.
To this day, hyperinflation experienced between 1920 and 1924 is a principle determinant of the German obsession about maintaining price stability through prudent monetary and fiscal policy.
Similarly, the great inflation between 1970 and 1981 has shaped the subsequent behaviour of market participants and policymakers.
The frequency of inflationary outbreaks in the past century has created the impression that inflation is the economic norm. However, the broader sweep of economic history suggests that this is not the case.
Economic growth is partly, and often largely, the outcome of making things cheaper and is intricately linked to rising productivity.
Declining prices allow consumers to increase expenditure on other items, thereby increasing living standards. In the longer run, growing productivity promotes price stability. The historical narrative supports this proposition.
The century between the end of the Napoleonic wars in 1815 and the start of World War One in 1914 witnessed strong economic growth and generally deflationary conditions.
After World War Two the productivity benefits arising from economies of scale gave business the resources to substantially increase wages creating a virtuous feedback loop in which rising incomes created greater demand, which generated even greater efficiencies.
In most countries this strong growth came with relatively stable prices.
This halcyon era came to an end in the 1960s as manufacturers started reaching the limits of the benefits of scale and productivity growth slowed.
After 1980 the exceptional inflation of the previous decade was tamed by a combination of globalisation, deregulation and new technologies. In a market economy, inflation is not the norm. When we think about inflation the question should not be why inflation is so low, but rather why there is any inflation at all.
From the inflationary decade of the 1970s onwards Milton Friedman had a profound impact on the thinking of key economic policymakers. The initial response of governments to the recession which followed the oil price shock of 1973 was to increase spending.
They were applying the remedy Keynes had advocated in the 1930s. However, this did not work. The world became trapped in inflationary stagnation.
Friedman had long argued that inflation is and always will be a monetary phenomenon and that the consequence of excessive creation of money is higher prices.
After 1979 the US Federal Reserve Board tried to implement Friedman’s ideas but rapidly found that it was not possible to manage the money supply as he proposed.
Almost by accident it discovered an effective alternative in the form of real interest rates, which promoted an efficient use of money and allocation of resources. The new monetary policy contributed to lower inflation by making the economy more efficient.
Friedman’s mantra that inflation is a monetary phenomenon seems to apply in markets which are insufficiently supplied with goods and services.
Excessive money creation in a closed economy is likely to cause inflation. Extreme examples were Germany in the early 1920s and more recently Zimbabwe and Venezuela.
It is noteworthy that in 1924, Germany rapidly brought inflation under control by managing its money supply as Friedman advocated. However, recent experience suggests that in a market economy open to global trade the outcome of excess money creation can be very different to what Friedman predicted.
Japan spent almost two decades trying unsuccessfully to combat deflation with massive money creation. More recently, quantitative easing in Europe and the United States has failed to stimulate economic growth as expected.
It boosted asset prices but not business activity. Much of the money created ended back in the central bank because the market had no use for it.
As is so often the case in economics, a proposition such as Friedman’s sometimes holds and sometimes does not.
Friedman’s biggest impact came not from his ideas about money but rather as one of the most articulate advocates of the market economy. The inflationary crisis of the 1970s prompted a rethink about the role of the state in the economy. Friedman’s ideas were embraced by Ronald Reagan and Margaret Thatcher.
Deregulation, privatisation and globalisation combined to promote economic efficiency and declining inflation. However, 40 years later, these ideas are increasingly under attack. The benign inflationary environment is at risk.
The role of central banks
As a consequence of widespread acceptance during the 1980s of Friedman’s ideas about the monetary cause of inflation, attention was focused on the activities of central banks.
It was argued that if inflation is a monetary phenomenon, central banks should conduct monetary policy to achieve a desired level of inflation.
The idea that central banks can manage inflation became mainstream. Over the following decade it became common practice to task central banks with the responsibility of achieving an inflation target.
Initially it seemed that the new paradigm was delivering the required outcome.
By promoting financial stability central banks created an environment favouring price stability.
The illusion developed that central banks could manage economic outcomes by setting interest rates appropriately and the fact that lower inflation was also due to factors such as globalisation and the complex interrelationship of economic growth and productivity tended to be ignored.
The first sign that the inflation-targeting model might not work came in Japan, which sank into economic stagnation after its long-running financial and economic boom came to a sudden end in 1990.
Its government responded with an ambitious programme of fiscal deficits, zero interest rates and massive money creation to get its economy going again.
Astonishingly this failed to create inflation and the deflationary conditions into which Japan had become trapped continued. This was the first warning that the inflation-targeting paradigm was flawed.
However, this was largely ignored, with condescending comments that the Japanese did not know how to manage a modern economy.
After the 2008 financial crisis China engineered a resurgence of its economic growth by massive monetary accommodation.
It was assumed by those who believed in the efficacy of monetary policy as a tool of economic management that what China could do in its closed economy could be done elsewhere.
Accordingly, when the US and European economies failed to resume former growth rates after 2009 their central banks resorted to zero interest rates and quantitative easing, which is a polite term for printing money.
The outcome was the same as the Japanese experience.
While quantitative easing has done wonders for asset prices, it has done little to promote real economic activity.
The proponents of these programmes have had to fall back on the counterfactual that things would have been far worse if they had not done what they did.
However, there is an alternative counterfactual that by promoting a misallocation of resources, quantitative easing actuallyreduced economic growth.
Whatever the truth, it is clear that the relationship between money creation and inflation is far more complex than previously believed and that the transmission mechanism between credit creation and economic activity has fundamentally changed.
A new inflationary threat
We are living in an era of astonishing political change. Concerns about global climate change and a sense that the market economy enriches a few rather than many are increasingly determining political agendas.
Those seeking political office are increasingly promising to address these concerns with lavish government spending. Given the parlous state of government finances in most countries, and the rising cost of pensions and healthcare, these new spending programmes are simply unaffordable.
Increasingly advocates of higher spending are looking to bypass this financial impediment by simply printing the money.
They argue that the limited inflationary impact of a decade of extremely low interest rates and quantitative easing constitutes a new permanent reality, which renders unnecessary what was traditionally regarded as financial prudence.
There is a real danger that we are inexorably moving into a new political era where the bitter experiences of the 1970s have been forgotten.
Massive spending on decarbonising the world economy may be justified but will come at considerable cost, not only financially but also in terms of economic growth and living standards.
In the enthusiasm of the moment these costs are largely being ignored.
Countries that embark on large-scale incremental public spending programmes financed by printing money may find that they inexorably move into the situation described by Milton Friedman, where excessive creation of money translates into inflation.
There is a prevailing complacency among central banks that they will be able to manage any such inflationary outbreak.
However, the experience of the 1970s suggests that once an inflationary spiral develops it is very difficult to control. Inflationary dangers arise not from the normal operation of market economies but rather from imprudent political interventions.
Worldwide, political agendas are evolving in ways that threaten current price stability.
Why is inflation in South Africa so high?
South African inflation has been persistently higher than in other market economies.
This can be regarded as surprising because we have an open economy with a powerful private sector, a well-developed financial system and a central bank which is both competent and prudent.
It would be reasonable to expect that our inflation would track global norms.
There are three principle reasons for our anomalous situation.
Firstly, the government has imposed on the private sector numerous obligations which have increased the cost of doing business and eroded economic efficiency. Secondly, mismanaged public monopolies have imposed huge costs on the rest of the economy.
Thirdly, for many years, per capita remuneration has grown at a much faster pace than inflation – in particular, the government has allowed its wage bill to get totally out of control.
Given the dire situation in which we now find ourselves it is possible that things will start to change.
For some years the private sector has been managing its remuneration costs so that they grow in line with inflation; government is now in a situation that it has no choice but to do likewise.
Recently inflation has tended to surprise on the downside and, given that inflation expectations remain elevated at around 5%, this is likely to continue. In November 2019 it was 3.6%.
The South African Reserve Bank has responded to lower-than-expected inflation with caution. Its mandate involves both price and financial stability.
There are good reasons why interest rates should be kept unchanged until there is more certainty as to how the government’s fiscal challenges are to be resolved.
However, there are also strong arguments that, given current inflationary trends, interest rates are too high.
The US Federal Reserve Board’s Open Market Committee argued that its most recent interest rate cut should be regarded as a recalibration of interest rates to a more appropriate level. Similar language can be used to justify rate cuts in South Africa.