 Inflation. Inflation? Inflation. Inflation is an economic bogeyman. Kept in check throughout the rich world since the 1980s. The rising cost of living is now back at the top of the economic agenda. When demand is greater than supply, either you get shortages or you get price increases. And actually what we had was a mixture of both. But as the pandemic subsided, at least in the West, the Russian invasion of Ukraine put more pressure on the global economy. At the moment when the demand-driven inflation was starting to fade, he had then had the horrendous consequences of war in Ukraine. And of course, there's all sorts of humanitarian consequences which are very tragic. There is also an economic consequence. Far from being the obvious outcome of the simplest economic laws, inflation is a highly complex beast. It's not just an economic phenomenon, but a psychological one, a societal one. And when it comes to the dreaded hyperinflation, it's a historical one too. We are genetically programmed to remember negative consequences, like rising in prices. So what is inflation? Is it here to stay? And how do we stop the cost of food and fuel and other vital goods spiraling out of control? Paul Donovan, the chief economist of Swiss Bank UBS, joins us to break it all down. Inflation is the change in prices, generally speaking. But there's, of course, lots and lots of different prices. So the inflation rate that we most often tend to hear about is consumer price inflation, which is sort of this mythical average consumer's basket of goods that they buy. What is the change in the price of that basket of goods? But there's other forms of inflation as well. When we are looking at equity markets, one of the most important forms of inflation is producer price inflation, which is the price companies charge other companies, not consumers, but other companies. And that's because most companies don't actually sell to consumers. Most companies sell to other companies. And then you've got things like wage inflation, which is how much a wage is going up, obviously enough. So there's lots and lots of different forms of inflation. We tend to focus on consumer prices. But in actual fact, you need to be quite careful in deciding what is the most appropriate inflation rate to use when you're analyzing investment decisions or the economy, because it may not be the consumer price inflation, it may be something else in target. Well, the way that inflation is normally measured is that you take a basket of goods. So let's use consumer price inflation as our example. So what you do is you say, okay, well, how much US households spend on food? How much do they spend on energy? How much do they spend on medical care, education and so on and so forth? And then from that, you derive the weights for how important each price is. So if households spend, let us say, 10% of their household budget on food on average, then food prices should be 10% of your inflation basket. And so when you calculate inflation, you'll take the food price change, the food price increase, because that's what we're measuring, and you multiply it by 10% and you add it into the inflation number. Now there's some issues with this. And the first issue, which is really important, is inflation is a plutocratic statistic. It's calculated on the basis of $1 vote, not one person won't vote, because you're measuring the weights by how much money is spent. If you spend more money, you have more votes as to what goes into the inflation basket. And so the result is the quote, average inflation rate tends to measure the higher income consumer's spending pattern, not the low income consumer's spending pattern. And that can be quite a significant problem at times, because from time to time we get this issue of inflation inequality, where the things that low income people are spending their money on are going up in price a lot, and the things that high income people are spending their money on are not going up so much. And that can then create this situation where most people actually experience an inflation rate that is higher, or from time to time lower than the reported inflation rate. And that's something that we are probably starting to get at the moment, because food and energy prices have been rising, and lower income people tend to spend more of their budget on food and energy prices, but the CPI reflects what higher income people are spending, not what lower income people are spending. Well, there's a couple of reasons. The first is, as per inflation inequality, it might be worse than it is as far as you're concerned. And we've got to remember, you're dealing with an average over a very wide economy, the chances are that the things that you're buying are not exactly the same as the things which are going into the inflation basket. But then there's also this combination of factors which come from behavioral economics, and these are loss aversion and frequency bias. So loss aversion is the fact that people remember bad things more than they remember good things. We are genetically programmed to remember negative consequences like rising in prices. And this goes back to sort of basic survival. We run away from the saber-toothed tiger three times more quickly than we run towards the next people. So that means that when prices go up, we remember them. But when prices go down, we're less likely to remember them. The second thing is frequency bias, which is we remember the price of things that we buy very, very frequently. We are less likely to remember the price of something we bought two years ago, but that's still relevant to our overall cost of living. So that means that when we see rising food prices, rising fuel prices, because people tend to buy food very regularly, because they're buying fuel for their car very regularly, maybe they're paying for transport on a regular basis like public transport, people remember the price increase because every single time you go to the vending machine to buy a Snickers bar, you're reminded the price of the Snickers bar has gone up, and if the price of the Snickers bar has gone up 20%, you think, well, everything's going up in price dramatically. The reality is that you probably don't eat that many Snickers bars in a single day, but you remember the price because every single day you're being reminded the price has gone up. The fact that your television two years ago was cheaper than the television you bought seven years ago, you don't remember that. You just remember the price of the Snickers bar and it creates what we call an inflation illusion. So this combination together, we remember the price increases more than we remember the price declines and we remember the high frequency purchases more than the occasional purchases. That combination very often creates an inflation illusion that people believe inflation is higher than it actually is. Well, what we've got at the moment is two different effects coming together to create what by recent historical standards, at least quite high inflation, though it probably doesn't last at these levels for that much longer. So the first thing is that in 2021, what we had was a simply extraordinary, absolutely extraordinary level of demand for goods. People were buying stuff and the reason people were buying stuff was that throughout the pandemic you'd not been able to go out and buy stuff sitting at home. And people were therefore effectively forced to save money. You've still got an income, at least in developed economies where social security systems provided you with an income, but you couldn't spend that money. So what's the result? Well, the result is your savings piled up. As soon as the restrictions are lifted, you've got a pile of savings that you didn't actually want to have and you've been sitting at home looking at your interior decor, watching home makeover programs on Netflix. What are you going to do the moment the shops are open? You're going to go out and buy new furniture and refurnish your home or you're going to redo the kitchen or buy a car or whatever it is. And so we get this extraordinary surge in demand for goods. And that has pushed up inflation because we did actually see also an extraordinary surge in supply of goods, but the demand for goods was so unusual, it overwhelmed the supply. And when demand is greater than supply, either you get shortages or you get price increases. And actually what we had was a mixture of both. But some of that surge in demand pushed up prices. Now that started to fade because of course by the end of last year, in a number of countries, that stock of savings had disappeared. It had been spent. You'd bought your 54 inch flat screen TV. You'd bought your new washing machine or whatever it was. And so the demand was coming down. And so that inflation pressure has started to fade in 2022. So we've still got some of that inflation pressure there, but it's on its way out. So if you look, for example, at television prices in the US or elsewhere, prices were rising last year, they're now falling. You've now actually got negative inflation. Used car prices were going up extraordinary amounts in 2021. And in the last few months, they've started to turn negative again. So we've started to see a correction, but there's still enough of this lingering effect that it's adding to the inflation. But what's come on top of that is that at the moment when the demand-driven inflation was starting to fade, we have then had the horrendous consequences of the war in Ukraine. And of course, there's all sorts of humanitarian consequences which are very tragic. There is also an economic consequence. And that is that although Russia is not actually that significant as an economy in terms of its size, it's significant in commodities. And so what this has done is lead to higher commodity prices, partly because there have been constraints on supply, either because the planting season for crops in Ukraine has been limited, or because companies are less willing to purchase Russian oil, for example. But also because there's a risk. It's not just that you're seeing prices go up because supply today is constrained. There's also going up over concerns that the war will disrupt future supply. And so what that has done is push up commodity prices. And that does feed through to inflation. Now, this is where things get a little bit complicated because if I say, well, the price of oil is going up, people immediately say, well, if crude oil is going up, your petrol is going to go up by the same amount. That's not necessarily so because, of course, you don't pour a barrel of crude oil into the tank of your car. There would be dire consequences if you did. The prices that we pay for food, for petrol, for airfares, and so on, which are reliant on air fuel, these are commodities plus an awful lot of labor. And in the case of food, an extraordinary amount of labor in a developed economy, now 15, 20% of what we spend on food is actually going on food. Most of what we spend is going on labor, which is delivering and processing, retailing, advertising. All of that comes out of what we spend on our loaf of bread. The farmer doesn't actually get that much. But with oil and with certain food products, it does have a pass-through. Globally, if I look at oil prices, crude oil is just under 2.5% of a typical inflation basket. And then you've got a lot of labor turning that crude oil into gasoline. But of course, if the crude oil price goes up by 100%, that will add just under 2.5% to your headline inflation rate. And that's pretty much what's going on at the moment. Interesting question depends where you are. In the United States, I think inflation probably peaked in March. The UK, it'll be a little bit later. Europe, it'll be a little bit later still. The direction of inflation in the second half of this year, I think is going to be downwards. And that's really for three separate reasons. The first, as we've already discussed, a lot of the areas where prices were really being pushed up last year by that absolutely extraordinary demand, we're now seeing the inflation rate come down. And in some cases, the inflation rate turned negative. And that's going to happen to more and more goods as we go through 2022. So the extraordinary demand is fading. As the extraordinary demand fades, the extraordinary prices will also fade. Second, and this is the big one, is what we call base effects. The most common way inflation is quoted is the year over year change in price. Now, when you think about that, that means that the year over year inflation rate that we always quote is telling us not just about prices today, but also about prices a year ago. And what we are doing, say, in March of this year is comparing the prices in a normal economy in March 2022 with the prices in a lockdown economy in March 2021. And of course, if you're comparing normal to lockdown, there's going to be a change in prices, which is going to be quite sizable. As we go through this year, say by June, we're going to be comparing, at least in the States, a normal economy in June 2022 with a normal economy in June 2021. And the price change is obviously going to be less dramatic at that point. So that will lower the year on year inflation rate. Now, that's also why different economies peak at different times, because different economies opened up at different times. So Europe was still more or less in lockdown in April 2021, for example. So you're still in April going to be comparing normal with lockdown for Europe, but in the States, you're going to be comparing normal with getting back to normal. So that's why we've got these slightly different things. The third reason I think inflation comes down is sort of the absence of the inflation pressure that would really worry economists. And that's a wage cost price spiral. So we're not seeing wage costs really rise in an inflationary manner at the moment. Wages are about 70, 70% of inflation in a developed economy. So it's the big one. It's the thing we really focus on. And we're not really seeing wage costs go up. Now, it's wage costs, not wages. That's an important distinction, because if you are paying people more money because they're working harder, as I repeatedly remind my boss, that's not a problem. That's not inflationary at all. And what we're seeing in most economies is that people are working harder. Generally in developed economies, economic output, GDP, is above pre-pandemic levels, but employment is below pre-pandemic levels. So you've got fewer people producing more stuff. If you're paying fewer people a bit more money to make a lot more stuff, that's not an inflation problem. And that argues against there being an inflation concern in the second half of this year. Well, to some extent, the best thing governments can do is nothing in as much as governments really can't change the oil price. Central bankers can't suddenly change the price of wheat or other commodities. There are certain things that governments can't actually do that much about. Part of the pricing inflation story is coming down on its own. It's naturally coming down. And then there's other things like fuel and food prices, the consequences of war, which really governments can't influence that much. We have seen in the United States and elsewhere parts of what's called the strategic petroleum reserve being pushed into the market. Governments have stockpiles of oil, which they release for sale, and that has a small impact on prices, and that's fine, but there's not that much that governments can do. There's a different question about whether governments should try and mitigate the consequences of the higher inflation. And there are things that they can do. They could either look at benefits that are being paid to try and help people afford the higher prices or where something is taxed. And of course, oil is very often taxed. They might feel, okay, well, we could temporarily lower the tax on oil. We could reduce sales taxes on other products and try and make it a little bit more affordable for people. So there are things that governments can do to mitigate the effects of higher prices in the short term, but governments can't change oil supply and demand themselves, at least not in the short term. If we're talking over the next 10 years, then yes, of course, governments can encourage investment in renewable energy and so on and so forth, but in the short term, there is a limit to what governments can do to offset price increases. What they can try and do is mitigate the damage to standards of living that come about from the price increases. Hyperinflation is... There's no precise definition. It's one of these made up terms in economics, but it's very, very high inflation and you normally associate hyperinflation with inflation rates of over 30% a year. That's an environment where if you're holding cash and you're not earning a rate of return, your cash is losing its spending power, losing its value very, very quickly. So hence, roughly 30% year-over-year inflation rate will do it. The thing about hyperinflation is that a hyperinflation episode generally causes a transfer of wealth away from savers and towards borrowers because the savers are watching the value of their savings go down, but the borrowers are watching the value of their debt, the amount of money they owe in real terms, also go down. So you're creating a shift of wealth in society away from savers and towards borrowers. And that can be very disruptive, of course, because people... We go back to the loss aversion. People don't like losing things and if you're seeing the money that you've worked hard over your lifetime to build up, if you see savings you've accumulated to finance your life in your old age, that's suddenly starting to be turned into a worthless pile of paper. That's something which is very, very corrosive, very, very negative, and people react very, very strongly to it. The debtors, of course, are very, very happy, but the savers who are seeing perhaps 20 or 30 years worth of hard work disappear in terms of its spending power overnight. That creates a very, very negative situation. And so we tend to find that episodes of hyperinflation are very socially disruptive because people really resent the fact that they are being penalized for having worked hard, being penalized for having prepared for their old age and their retirement and so on and so forth. They really, really resent what's happening. And the interesting thing about episodes of hyperinflation is that the legacy of a hyperinflation episode lasts in many cases for generations, two, three generations, because the people who experience the hyperinflation are very, very opposed to inflation thereafter because it's been so catastrophic to them at a personal level. And it's not just them. They tell their children and their grandchildren about it. And so very often in societies that have experienced hyperinflation, you will find that a lot of people are very, very sensitive to inflation, very, very opposed to inflation, not just for a generation, but for three generations afterwards. Germany, which, of course, had hyperinflation in 1923 and then again immediately after the Second World War, you have a strong cultural tradition opposed to inflation. Singapore, where a lot of nationalist Chinese refugees had experienced hyperinflation in nationalist China in the 1940s, again moved to Singapore and bring with them this cultural fear of inflation and this abhorrence of inflation driven by this hyperinflation story. So there's lots of examples of this around the world where it goes on for a very long time because the social consequences, as much as the economic consequences of hyperinflation are so damaging.