Exaggerated Expectations – Investors’ Chronicle
Imagine an amoeba in a sci-fi horror. A moment, it’s barely a point in the Petri dish; the next moment he took over the laboratory. It is, if you will, the horrific caricature of inflation feasting on itself, whereby inflation breeds inflation in a pernicious feedback loop that kicks in relatively easily in the UK. So, the frightening thought to itself, who knows what long-term effects may be caused by the current UK inflation rate rising 3%, triple the rate it started in 2021?
But, in fact, should economists in general, and those at the Bank of England in particular, be so obsessed that once inflation is higher it ensues even more in a self-sustaining process? The logic is that in wage negotiations, wage agreements are forced upwards by employee representatives worried about accelerating inflation. So the very rise in inflation that was feared becomes a reality and so on.
Right now this fear is pervasive and you can see why. Among the G7 group of the world’s largest democracies, only Italy has a worse record than the UK when it comes to controlling inflation. In addition to possible damage to monetary policy, rising inflation is hurting livelihoods in the real economy.
Even from an investor perspective, the implications for stock value are mixed at best. At the very least, the more inflation rises, the higher the minimum rate of return a portfolio must achieve before its returns become real. Meanwhile, the price of securities whose value depends on a fixed stream of payments must fall, and some stocks fare better than others, largely based on the ability of firms to offset their rising costs without too much to hinder demand.
However, according to an article published this month by Jeremy Rudd, an economist at the US Federal Reserve, the US central bank, the misconception that inflation expectations drive inflation up in the future is largely based on lazy thinking. . Simply put, there is a tautology at work – inflation expectations are assumed to be important because they have always been assumed to be important; or at least since 1968, when Milton Friedman ascribed to them a role in shaping the trade-off between wages and employment in the highly influential equation known as the Phillips curve.
Yet one problem is that, almost by definition, expectations are elusive. Rudd quotes fellow economist Robert Solov in a 1979 article, “What We Know and Don’t Know About Inflation”: “I’m still a little dubious about the call to expectations as a causal factor; expectations are by definition a force that you intuitively feel must always be present and very important, but somehow you are never allowed to directly observe.
It doesn’t matter that you can’t see the inflation expectations, it was enough for prominent economists to say they were there. Friedman’s work – and that of others – was based on the idea that there is a divide between the side of the economy that deals with “nominal” prices, where knowledge of inflation is somehow absent. , and the “real” economy, which is on the streets and deals in inflation-adjusted amounts. Consumers, employers, and employees may switch to the nominal side of blissful ignorance for a while, but sooner or later reality lifts and their attention will turn to the real side. This is when self-interest means inflation expectations kick in – there is no point in negotiating a wage settlement that ignores price movements in, say, 12 months.
Combine this plausible idea with the sustained rise in inflation during the 1960s and 1970s, which seemed to be consistent with the Phillips Curve message that full employment – and bargaining power – would lead to increased earnings. wages and, according to Rudd’s article, “these developments were seen as a resounding victory for the prediction that expected inflation was an important determinant of real inflation.”
Later, in the 1990s and beyond, for central banks, which had a mandate to control inflation, monitoring and managing expectations became an important part of their job. The fact that for many years from the late 1990s onwards inflation remained subdued indicates that bankers were right to focus on expectations and did their job well – impressions they did not were all too happy to feed.
However, Rudd suggests that self-deception was at work. The presence of expected inflation already in models endorsed by influential economists was the main rationale for the view that expectations actually affect prices. His sardonic conclusion is that this “apotheosis occurred with a minimum of direct evidence, an almost nonexistent examination of alternatives that could do a similar job corresponding to the facts available and without introspection.”
Further, he argues that in the United States at least, where unionized industries account for only about 6 percent of jobs, a formal wage bargaining process no longer really exists. Instead, he suggests that while inflation remains subdued, it is only a minor concern for employees. There are therefore few attempts to exceed expected inflation by negotiating higher wage agreements. Overall, it is satisfactory that the annual settlements are measured against current inflation rates.
Still, studies from the 1970s suggest that there are inflation levels that change the outlook, causing negotiators to look deeper. One of these studies indicated that this occurred when the general consumer price inflation rate exceeded 3% or when food price inflation reached 5%. Admittedly, such levels have been exceeded from time to time over the past 25 years without a sustained spiral in wage prices, the most damaging period being when inflation has remained stubbornly high at the bottom. following subprime mortgages in the United States in 2008-09. crisis. The best explanation is that employees thought – or had little choice but to assume – that the price increases would revert to a long-term average.
In diluted form, what applies in the United States probably applies to the United Kingdom. So where does that leave us? The table below offers mixed messages. First, the curve showing the rate of increase in employee wages is interesting but not so instructive. Changes in earnings are not changes in wage settlements. The former are much more volatile, being linked to economic activity. So, year on year, they briefly turned negative in mid-2020 and are currently increasing at their fastest rate in the 21st century. The changes in wage agreements are much calmer. A year ago, according to XpertHR, a consulting firm, the median settlement across the economy was just 1%. In August it was 2%. While it had doubled, it was one percentage point behind consumer price inflation in the UK. The question is to what extent this gap will be closed further, due to labor shortages.
Listen to the pessimists and the UK’s supply side struggles will persist, pushing inflation, as measured by the Consumer Price Index (CPI), topping 4 percent by the end of the year. year. Already, the prices of nearly a quarter of the CPI’s basket of goods are rising more than this rate.
The conventional view is that this should boost expected inflation, adding further upward pressure to the mix. Either way, Rudd’s suggestion is that the best central bankers can do is keep silent about expected inflation; the more they tap on it, the more they favor the result they least want. Think of it in terms of that sci-fi metaphor we started with. Eventually, the boffins realize that the amoeba only grows when it knows it is being talked about. Solution – shut up.
The results of ad operator JD Wetherspoon (JDW) are still entertaining thanks to the thoughts of founder and president Tim Martin. This year’s numbers were no exception. Martin spoke about his usual hatreds for pets, one of them being the UK’s corporate governance regime. Of course, a system designed to give the impression of virtue must always be suspect. It aims to bring rigor in the management of companies but also serves as a cover for the extraction of rent by managers. When all the boys and girls come from the same school and mark each other’s homework, what else would you expect?
Martin’s particular scarecrow is that corporate governance rules encourage the turnover of non-executive directors. He says it undermines successful businesses by eliminating seasoned administrators who understand the “DNA” of a business. His solution is to promote worker administrators to the Wetherspoon board because, as he said The temperature, “The knowledge of experienced managers greatly exceeds mine”. May be.
However, there is a larger point underlying Martin’s intentions. The pool of capable people who could do a job as a non-executive director is arguably larger than conventional wisdom allows. Possible proof of this is the growing number of non-managerial women over the past 15 years. Of course, the process was driven by checkboxes, but – as far as one can tell – this did not lower the level of corporate governance; this, despite the annoying fact that the average female non-executive’s CV is less impressive than that of her average male counterpart. Of course, this depends on the practices and prejudices of the past – men generally got the best jobs. Thus, increasing the number of non-managerial women means that the quality of CVs has been diluted even though the quality of appointments has not (to our knowledge).
Yet the larger point is that this logic will not only apply to potential female directors. There are a lot of people out there – of all shapes, descriptions and resumes – who are well capable of filling the non-executive role. And it’s not even about diversity in itself; it’s about getting better business results. Sprinkling the process of worker managers surely won’t hurt.