If you look at UK inflation over the last few centuries, you are immediately struck by the change that occurred after 1945. Until then, inflation took place mainly during major wars and then periods of deflation followed where prices largely came back down. So, why did that not happen after 1945 and what implications does that have for us today?
Why inflation took off after the war
My new book shows that there are a number of factors. One of the main reasons for the change was the adoption of Keynesian thinking by governments around the world. Politicians simplistically took from the General Theory the idea that inflation was a necessary consequence of high employment.
At the same time, the UK emerged from World War II with debts of 237 per cent of GDP. Encouraging inflation helped to reduce the debt burden. The policies that encouraged inflation were largely justified on the grounds that inflation would help employment levels.
On the other side of the Atlantic, the US also encouraged inflation by following a policy of monetary expansion and specifically tasked the Fed in 1951 with targeting a persistent (low) level of inflation. What the US did mattered critically for the UK because of Bretton Woods. The UK then imported extra inflation from the US because of the pegging of the currencies. Indeed during that period, UK and US inflation had a correlation of over 70 per cent. In more recent times, the Bank of England has had an overt target for positive inflation too.
The other two factors that have encouraged inflation in the UK are the rapid expansion of the money supply (especially in the 1970s and 1980s) and the increase in commodity prices – though the effect of the latter is very much a ‘one-off’ rather than creating continuing inflation. Rises in commodity prices have been exacerbated by the long-term decline in the value of the pound and repeated devaluations, themselves a consequence of monetary laxity. The chart below summarises the main causes for all the inflation peaks since 1940.
Data source: Inflationtaxbook.com
All these factors persist and prices continue to rise almost unabated in the UK. For example, prices have gone up by about a half since the millennium.
Data source: ONS
The insistence of describing inflation in terms of the annual change, rather than an index, has helped disguise this critical fact from the general public. Framing inflation as a rate of change ensures it is almost always a small number and one which people tend to ignore. Furthermore we are told that 2 per cent is our inflation target so, again, most assume that this level is okay.
This may not matter much if those expectations were correct. However over the last few years, inflation has been persistently higher not just than the Bank of England's target but also their central two-year projections - see graph below. The cumulative effect of this unanticipated inflation is probably quite significant for any counterparty to a contract affected by inflation.
Data source: Bank of England February inflation reports
The issue is made even worse, in my view, by the March decision of the ONS to only focus on CPI as the headline number in media reports. The CPI produces estimates of inflation that are about 1 per cent lower than RPI purely due to its method of construction.
Impact of inflation
But does inflation really matter and have an effect on us? In theory, if inflation is properly anticipated we can allow for it. However we live in unusual times and the effects of central bank polices and financial repression mean that counterparties are not being hedged correctly against inflation and inflation has been significantly above target for some time.
There is one clear winner. Inflation is helping governments deal with their debts. As a measure of how successful that policy can be, Ray Dalio, the founder of the Bridgewater Associates hedge fund, recently estimated that nearly 80 per cent of post-war UK government debt was just inflated away in the period 1945-1969. Currently I estimate the government is gaining around £50bn a year in effective debt relief and this is set to substantially increase as our debt pile escalates over the coming years.
So if the government (and other debtors) are gaining from inflation, who are the losers? The main payers of inflation tax are:
- Pension funds: Together with life funds, pension funds are major holders of government debt and are suffering directly from the reduction of the real value of their bonds and interest payments. Moreover, recent legislation has effectively caused them to have to hold even more. This is at a time when it is likely that prices of bonds have peaked and these funds risk substantial capital losses in the years to come, further impacting on pension values.
- Savers: The combination of inflation and low interest rates, as part of the financial repression policy, is having an impact on the wealth of everyone with cash savings. I estimate that over the last four years, the average saver has lost 11 per cent in purchasing power terms on their savings. This is a far greater amount than the original proposed loss to uninsured Cypriot savers that caused such widespread civil unrest.
- Workers: Over the last four years of published data (2008–2011), the average UK household income has not increased. According to the ONS Family Spending Survey figures, the average gross weekly income was £713 in 2008. In 2011, it was still just £713. Over this period, the Retail Prices Index gained 12.5 per cent. There is still no sign of wages rising significantly. They are certainly not keeping up with inflation.
Inflation may be low but it still matters. Moreover it is probably eroding your personal wealth and reducing your standard of living.
Pete Comley is the author of Inflation Tax: The Plan to Deal with the Debts.