Inflation means a tough 2023 – but this isn’t the 1970s all over again

Last week, the world’s central banks showed they were frightened – and as long as they are frightened, the rest of us can relax a bit, writes Hamish McRae

If people can earn good money they will spend it, which in turn supports overall growth (Getty)

Well, last week did indeed turn out to be a disturbing time for the world economy. A number of central banks, including the Federal Reserve and the Bank of England, increased interest rates as predicted. But what was not foreseen was the market reaction.

Shares in the US initially shot up on the Fed’s action, then plunged, leaving the S&P 500 index slightly down on the week. In the UK, while the increase in rates was expected, the message of the Bank of England that inflation might exceed 10 per cent this autumn and that the economy was in danger of recession, was not. Both shares and the pound fell sharply.

But this is not just about interest rates and inflation. There are other headwinds, including of course disruption from the war in Ukraine, and also the struggle China is still having to contain the pandemic. Shanghai, its largest city and port, remains locked down, with knock-on effects on global supply chains.

Indeed, if you want to pile up all the things that are going to depress the world economy in the coming months, we are looking at a grim year. The R-word, recession, is being increasingly heard, and since it took 20 years and two global recessions to clobber the inflation of the 1970s it is easy to see why.

If, however, you look at what was really new information last week, there isn’t really very much. What seems to have happened is that the fears of recent months have become crystallised, in the sense that there is now a widespread appreciation that the central banks have no option but to crush inflation and that action will carry costs. In facing that, we have to try to sort out the realities from the fears. So the new question is: how big will those costs be?

The first thing to say here is that inflation will come down to some extent of its own accord, once the so-called base effects of the current bout of price increases move out of the system. Think of it this way – a year ago, the Brent oil price was around $65 a barrel, and now it is $113 a barrel. So it has nearly doubled and that has increased energy prices everywhere. But a year from now, it is not going to double again.

It has never been over $200, indeed when it touched $140 in 2008, it quickly fell back. At present, it is pretty much at the top of its trading range this century. So let’s say it stays roughly where it is now. In a year’s time, there would be no inflationary force from oil. There may be other things that will be pushing up inflation, but not energy.

I expect interest rates everywhere, including the UK, will indeed move a fair bit higher. But if inflation comes back to something like 4 per cent, then we won’t need terrifyingly high rates to control it. So while the costs of mortgages will rise, they need not climb to a level that would set off a housing crash. If this is right, then the view of the home-lender Halifax last week will prove right too. It was that while prices were now at a record, up 10.8 per cent on the year, growth will tail off later this year. That would be a benign end to what has been a socially damaging time.

Just as it is in no one’s interest to trigger a housing crash, it is equally troubling for housing to remain unaffordable for would-be first time buyers. So while there have been house price crashes in the past, most recently after the 2008 banking collapse, there is no inevitability that there will be one now. And if house prices remain solid, that supports consumer demand, which in turn supports the economy as a whole.

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A further reason for hoping that we may dig our way out of this bout of inflation without a recession is that the UK job market is still very strong, with the largest number of unfilled vacancies ever. Much the same situation applies in the US and Europe. If people can earn good money they will spend it, which in turn supports overall growth.

Finally, there is something else happening to the structure of all advanced economies. We are learning how to use technology to increase efficiency because we have been forced by the pandemic to innovate. We have all experienced this in our daily lives, from shopping online to meeting by Zoom. This wave of innovation will increase productivity in the future, indeed for years to come.

Pull all this together and the message, I suggest, is this. There will be a slowdown as the central banks crunch down inflation. That slowdown will be evident by the end of this year, and 2023 will be difficult. But this is not like the 1970s, when inflation was out of control. Last week was an important one in that the world’s central banks showed they were frightened – and as long as they are frightened, the rest of us can relax a bit.