The Crucial, Overlooked Point in the Argument for Stubborn British Inflation

Here we go again. Over the weekend, a former member of the Bank of England’s (BoE’s) Monetary Policy Committee—and now the head of an international economic think tank—made waves with an op-ed arguing the UK is poised to diverge from the rest of the world’s disinflationary trend.^[i] This aligns with sentiment we have seen toward the UK these days, and in our experience, it comes with chatter around higher-for-longer interest rates hitting the economy and public finances—and, by extension, stocks. Yet we think it misses the mark, rendering this a brick in UK stocks’ proverbial wall of worry, in our view.

The op-ed, which featured in The Observer, claims three factors unique to Britain make it unlikely to enjoy a return to more normal price conditions.^[ii] Those factors? One, wage gains have accrued to high-income workers, teeing up industrial actions and big pay hikes for industries with wage shortfalls (e.g., public health, safety and transport)—both of which it deems inflationary.^[iii] Two, more Brexit growing pains as certain grace periods for EU standards and products run out, raising costs and reducing imports. Three, uniquely erratic boom-and-bust fiscal policy where short-lived positivity from tax cuts and spending alternates with austerity, bringing low productivity and weak gross domestic product (GDP, a government-produced measure of economic output) growth even before inflation is factored in. Cue the stagflationary malaise.^[iv]

We could probably spend 1,500 words on any one of these in turn, exploring the merits as well as what we think are the fallacies before arriving at the conclusion that most of the argument amounts to speculation, and that a lot of underlying assumptions would have to prove correct for the forecast to pan out. But we think there is a larger philosophical error here: It is the same Keynesian-style argument we have seen monetary policymakers and economists globally make for more than three years now (referring to the economic school of thought pioneered by economist John Maynard Keynes in the early/mid-20^th century). This school of thought views demand and governments as the drivers of all activity, including prices. The inherent assumptions are the same that led monetary policymakers to presume their 2020 COVID interventions wouldn’t prove inflationary.^[v] And the same that inspired economists and policymakers to deem it near certain 2022’s steep rate hikes would induce painful recessions (periods of contracting economic output)—necessary medicine to cure inflation.^[vi] And now these are the same assumptions that make many economists we follow question how inflation has slowed markedly without spiking unemployment and broad economic problems.^[vii] Broken clocks aside, if this logic has been so wrong for so long, we think the likelihood it is suddenly right seems low.

Now, to be clear, we aren’t inherently for or against any economic school of thought. But the root error here, in our view, is ignoring the monetary and supply side of things—as in, inflation is always and everywhere a monetary phenomenon of too much money chasing too few goods and services. Monetary policymakers spiked the money supply in 2020, notching unprecedented growth rates in the broadest measures of money throughout the Western world—whilst lockdowns impaired production.^[viii] Inflation followed at a lag, as it usually does.^[ix] Yet money supply growth has cooled substantially since then, and disinflation (meaning slowing inflation rates) followed at a lag.^[x] Now broad money supply has turned negative in some places, which is inherently deflationary.^[xi] The UK is one of those places, as Exhibit 1 shows. On a month-over-month basis, M4 money supply fell in five of seven months through June, the latest data available. Year-over-year, M4 is now basically flat.

Exhibit 1: UK Money Supply’s Wild Ride

Source: Bank of England, as of 28/8/2023. UK M4 Excluding Intermediate OFCs, January 2013 – June 2023.

If UK money supply isn’t growing, we have a hard time seeing how rapid price gains would continue from here. Yes, it is possible, but it would likely hinge on a repeat of severe supply shortages. In our view, that doesn’t appear to be in the offing. Rather, the massive supply disruptions that accompanied 2020’s money supply spike have largely resolved.^[xii] With those evened out and the monetary bulge apparently having worked its way through the system, we think price conditions look likely to be much more benign from here, bringing markets plenty of relief.