High debt and upward pressure on wages will make dealing with inflation increasingly difficult for central banks, according to CG Asset Management’s Peter Spiller.
A common caveat to inflationary concerns during the Covid-19 pandemic has been that the large deficits, accrued by stabilising economies, will prove to be a sufficient anchor on runaway inflation.
Ariel Bezalel, manager of the Jupiter Strategic Bond fund, recently argued that global debt, stagnant wage growth and the subdued velocity of money are just three of the reasons why inflation concerns will be a temporary blip – as oppose to a structural issue.
However, Peter Spiller, who has managed the Capital Gearing Trust for 39 years, argued the opposite – contesting that high debt makes inflation harder to control once it starts.
That said, he does agree that debt has its deflationary properties – but only in certain scenarios that aren’t comparable to the current climate.
The Capital Gearing Trust manager used the example of Japan in the 1990s.
He said companies were very leveraged and there was a huge real estate bubble which had been building throughout the 1980s.
“There’s no doubt that the weight of debt, in this case, corporate debt, can be very depressing in terms of activity and there are circumstances where it can be established as deflationary,” Spiller said.
“Famously, the garden of the Emperor's Palace was worth more on a per-square-metre basis than the whole of California.”
However, real estate prices in Japan fell 95 per cent over the next 15 years.
Companies had been content operating with high levels debt due to substantial real estate assets, but when the value of those assets fell, that represented a serious problem.
“The response was to cut back savagely on capital expenditure,” he said. “The savings rate for the corporate and personal sector absolutely soared.
“Everybody cut back on expenditure, notwithstanding the government that had run some deficits, but they just weren’t big enough to offset the massive increase in savings.”
Spiller argued that those conditions were unique and that “we are in a very different world now with respect to almost everything about that story”.
He said the problem now lies in how governments and central banks respond to these developments with fiscal and monetary policy.
“You could argue that inflation is more problematic when debt is high,” Spiller added.
He said the Bank of England argued in 2016 that, given the high mortgage debt rate, interest rates had to be kept low - five years on and mortgage debt is far higher.
“Even in 2016, a short-term interest rate as high as 2.5 or 3 per cent would cause more distress in the mortgage market then there was at the peak of the financial crisis,” Spiller said.
“That’s very important, because in my view, it means they will not raise short-term interest rates to anything like enough to deal with inflation.”
He said this would cause a huge crisis in the mortgage and banking markets.
“The first responsibility of any central bank, regardless of the targets set by government on inflation, is to preserve the integrity of the financial system. Because if that falls apart, everything falls apart.
“The high-debt circumstances we’re now in dictates that inflation - if it does get underway it will be very difficult to control.”
When periods of high inflation pass out of living memory, central banks are increasingly scrutinised, which also hampers their ability to curb inflation.
The sentiment towards the 2 per cent target rate of inflation has changed over the years, said Spiller.
“The sensitivity was entirely one way, so no one worried if it was a little bit under, but quite a lot if it was over,” he said.
He added that memories of high inflation had kept this sensitivity balance in check, but as time went by that symmetry began to level out as inflation worries subsided.
“The background has become neutral, if not slightly more inflationary,” he said. “However, the policy response is informed by the fact that the fear of inflation just isn’t necessary.
“The fear of inflation is what constrains budget deficits and if you don’t think inflation is an issue, you can print money and spend as much as you’d like.”
Indeed, a fifth of all US dollars were printed in 2020 to support the Covid-stricken economy.
“If we had the academic framework that we had 25 years ago, and the growth in broad money of 25 per cent in the US, there would have been universal agreement that rapid inflation was just around the corner.”
However, he argued that the great additional insight of the last 15 years has been the role expectations play and the emphasis of this in inflation.
“Central banks talk a lot about the transitory nature of inflation, if inflation looks as though its ingrained – then it carries on.”
He cited McDonalds raising wages by 10 per cent and Amazon now operating with a $17 an hour policy and a £1,000 signing-on fee showed that employment shortages are increasingly an issue.
Shortages of staff, especially in UK retail will also drive wages upwards.
“I think one of the reasons central bankers bang on about these prices being transitory is they hope to influence behaviour,” he said.
“So if they can keep expectations low then they’re fine, but if wages rise, then wages become the engine of inflation.”