Hello dear reader I hope that you are all enjoying the rather fine summer we are having here in unusually sunny Blighty (for any international readers I hope your current season has been equally enjoyable!).

And a Happy Birthday to me! For August is the month of my birth. That makes me a Leo and for all you budding Russell Grants out there I pretty much fit the Leo stereotype so score one for the mystics.

August is also the month which sees the commencement of the football season. The summer period of furious transfer activity (unless, like me, you are a Spurs fan in which case its furious fans complaining about the lack of transfer activity) and broad-based hope that “this is our season” will soon revert to anger, frustration and despair for most of us as we are once again forced to reckon with a team/manager that aren’t good enough to bring us what we want – the title (be that Premier League, Championship or GM Vauxhall Conference…crumbs I’m showing my age there). I, for one, love it and I can’t wait to enjoy a few beers in the sun and the first of many trips to the Lane (I steadfastly refuse to call it the “Tottenham Hotspur Stadium”) on Saturday (by the time you read this the result of our opening fixture against newly promoted Burnley will be known…if we lost please feel free to laugh at me – I am VERY used to it!). For now, I’d like to wish all clubs (except Chelsea, Arsenal and Liverpool) the best of luck for the season ahead.

Much as I’d like to spend my mid-month update talking about football, I fear that would lower the already paltry readership of our blog and would certainly play fast and loose with the brief.

Instead I’d like to return to a topic I covered in some detail back in February. Inflation.

The imposition by President Trump of large and pretty scattergun-looking tariffs has thrown a macro-Molotov cocktail into what was already a pretty tricky market environment. Broadly speaking I think investors are in one of two camps – those who are laser focussed on the price impacts and those who are more concerned about the growth impacts. Unfortunately for all of us it really looks like the Regional Presidents and Board of Governors who make up the Federal Reserve Open Market Committee (the US equivalent of the Bank of England’s monetary policy committee for those who have no idea who I am referring to – i.e. the folk who set interest rates) are just as divided.

The reasons for this division don’t just relate to the inherent uncertainty about how and when prices will be affected in the coming months. It actually speaks to something much deeper – inflation targeting central banks are ALWAYS challenged by inflation impacts which emanate from the supply side of the economy. Their tools affect demand, not supply, and thus their ability to affect what’s happening on the supply side is de minimis. This is not new information to the central banks themselves, nor the PhDs and economists who inhabit the basement of the Eccles building or write and comment on such matters.

However just because these issues are known does not make them any less worthy of attention.

In simple terms the challenge is thus. If demand is weak then that would tend to push inflation down, below target and so central banks will ease policy (cut rates) to stimulate demand and push inflation back up again (of course, as I said in my February comment, the extent to which they have done that in recent history is highly questionable in my humble opinion). Conversely if demand is too strong this will tend to push inflation above target and so vice versa they will tighten policy (increase interest rates) to slow demand and bring inflation back to target. That’s simplistic but indicative and broadly speaking it all makes sense.

When there are issues on the supply side however things get tricky. If there is a positive supply shock (simplistically speaking an increase in supply which lowers prices) this will tend to reduce inflation but not because of weak demand. In fact, it may increase demand as consumers can buy more of the goods which are cheaper. An example of this would be the mid-1990s up until the Global Financial Crisis. The increasingly integrated global trade system, culminating in China’s entry into the World Trade Organisation in 2001, resulted in a trend of “offshoring” of manufacturing. Basically, companies started making goods in countries which had very low wages, thus lowering production costs and passing on some of those benefits to consumers via lower prices. The Western world got lots of cheaper goods (clothing was a particular beneficiary but a myriad goods were involved) and developing countries were able to employ more of their population and increase their economic output. However, from a monetary policy standpoint – what should an inflation targeting central bank do if faced with falling inflation due to this wave of “globalisation”? The answer should be – nothing. It is “good” disinflation, benefitting consumers, not “bad” disinflation resulting from insufficient domestic demand. So, a) there isn’t a problem and b) none of the central bank tools can do anything about it whatsoever.

If you were to look back at that period, you would find very little debate about this issue. Why? Because inflation in countries like the UK and US was largely very close to 2% for much of the period (or indeed there were far more relevant things causing policy-makers consternation). Certainly, through the period now known as “The Great Moderation” (the 00s, pre-crisis) that was abundantly the case. Central bankers were instead falling over themselves to self-congratulate on what a great job they were doing. This is where the errors began. For you see that multi-year stability of 2% inflation was actually masking something less congratulation-worthy going on. Globalisation was pushing global goods prices lower and that global goods disinflation was being offset by domestically generated inflation which was considerably higher than the relevant central bank mandated targets (between January 2000 and December 2006 services inflation – a very, very strong proxy for domestically generated price pressures – averaged 3.25% in the US and 3.74% in the UK). So in that period the thing that central banks had no control over and thus should be discounted or excluded from the assessment of whether the economy was too hot or too cold was conveniently or naively masking domestically generated price pressures which were fairly loudly shouting that the economy was showing signs of overheating. That period ended with a once in a generation crisis caused by over-exuberance and over-leverage – 2 more classic signs of money being too cheap, too easy and too abundant one could not wish to see.

Fast forward to today. Today we are facing a significant negative supply shock. Not the good, giving, happy kind of “positive shock” I just described from a few decades back. No this is the bad kind of supply shock. This is one which likely raises prices and lowers demand. The extent to which it does so is hugely uncertain as it will be a function of corporate behaviour, consumer demand and price sensitivity (the price elasticity of demand if you want to engage in eco-babble geekery for a moment), industry-level competition, availability of adequate substitute goods, currency moves and, I’m sure, a host of other factors.

If we apply the playbook from the noughties then I suppose central banks should ignore the composition between domestic price pressures, which are indicative of domestic supply/demand balance, and global drivers, over which they have zero control or influence, and simply manage policy based on where total inflation comes out.

And why not? In spite of being more than just a little bit responsible for the GFC mess, in the humble opinion of your author of course, the history books now suggest that the central banks were in fact the heroes of that episode for printing gargantuan sums of money to clean up the mess and create an equity market which can only ever go up – who doesn’t like that! It worked fine for John Law and the East India Company…right?

So, if it worked last time then why not stick with it? Treat the inflation target as sacrosanct, reject deeper analysis and simply cut rates if CPI (or PCE if you’re the Fed) is less than 2% and hike rates if it is more than 2%. Simples! In fact, couldn’t we just get a computer to do that? Hurrah! Maybe at last I have found a valid use case for Generative AI – writing reams of waffle each month under the guise of “policy deliberations” before setting policy based on the aforementioned, and incredibly simple, algorithm.

Here's the problem. In fact, there are many problems but if I go too far down the rabbit hole, I know I will lose you (out of boredom not incompetence). Inflation, as discussed in February, is a kind of process. 3% CPI today doesn’t mean 3% CPI next year. And aside from all the global stuff which will affect prices, the main driver of inflation over the medium term is back to that domestic supply vs. demand balance, and in particular the labour market. If prices go up 10% and your wages don’t go up (or go up by less than 10%) then for most people that means they will buy less. Not out of choice but out of an inability to do otherwise. Inflation, without commensurate wage growth, sows the seeds of its own demise (it also sows the seeds of popular discontent as many politicians have recently found to their cost). Thus, the question to be asked is not if prices will go up so much as will the labour market allow those price rises to become self-fulfilling.

Stylistically this is what it would be like – in response to rising prices workers demand higher wages knowing that with low unemployment and high demand in the economy their employer will have to acquiesce for fear of missing out on profit. If firms suffer rising wage costs amid strong demand, they’re likely to pass on those higher wage costs via higher prices. So, workers will see that second increase in inflation and go back for higher wages. This is what a self-fulfilling inflation cycle looks like. THIS is the thing that independent, inflation-targeting central banks are supposed to guard against. If that process gets going and becomes entrenched it is terrible for everyone and the cost of stopping it rises exponentially the more acute it becomes. This is what we learned (again) in the 1970s. THIS is where central banks summarily failed after COVID.

Which brings us back to the current situation. Central bank rate-setting committees are publicly squabbling (they aren’t really engaging with one another so its not really a squabble but le mot juste escapes me) because there is an implicit disagreement about what they are supposed to do in this situation. If inflation is too high, then how can we cut now? What happens if inflation expectations rise? We need to see more data. Philosophically there are more holes than a Swiss cheese in that sort of approach. More data does not equal more certainty about any fixed point in time. One-time price rises are not the same as inflation. Policy acts with a lag so needs to be set for where we are going not where we have been. It looks messy and to be honest a bit amateurish.

What I can’t help feeling is that in fact the main driver of the shallow assessment and more hawkish viewpoints is fear. Fear of making the same mistake that they did after COVID. Inflation was dismissed as transitory and thus central banks were very late responding. They don’t want to do that again. Leave aside their massive risk management error back then (sure, inflation might have been transitory but continuing with 0% rates and massive QE while you waited to find out is a little extreme, no? Maybe dial back the irresponsible balance sheet expansion, possibly even nudge rates up a touch while you accumulate more evidence and then from that point you can leap in either direction as the situation becomes clearer) the biggest difference is the labour market. In the crazy post-COVID world, something crazy went on in labour markets. Stimmy-driven exuberant demand met an inflexible labour market, and the result was heat. White-hot heat. Massive demand for labour resulted in all sorts of skilled, semi-skilled and unskilled workers being bid up (by which I mean companies competed for workers via increased wages) as firms scrambled for workers. Thus, supply-side price pressures (the result of the world economy shutting down then attempting to restart overnight – turns out not a great idea) met a smoking hot labour market and the result was higher prices feeding higher wages feeding higher prices. In the calendar year 2021 the US added an average of over 600,000 jobs per month. That is heat. In the last 12 months it has added an average of just 128,000. In the last 3 months the average is a paltry 35,000. That’s not heat, it’s tepid at best – and for the record its tepid and cooling.

It's complicated. I get it. What concerns me most however is the idea that 2% CPI means policy is in the right place, even when there is really good evidence under the hood that it isn’t because of exogenous supply-side factors. Conversely 3% CPI means that policy is too loose even if it’s there for a different set of exogenous supply-side reasons and there is significant evidence of the sort of labour market cooling which has historically been a forerunner to a significant growth decline. Central banks have spent decades bouncing from error to error and it’s gotten to the stage where that wonky thinking is starting to become received wisdom. Where inflation is today contains information about things that monetary policy doesn’t influence and evidence of the appropriateness of monetary policy a year ago. Let’s all stop using it as naïve and simplistic justification for what the central bank should do this month or next month.

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