HAMISH MCRAE: War on inflation really is key

The pound had a decent week against the dollar and I would not be surprised if it is back to $1.40 in the coming months. 

As noted here last week, there is a growing consensus that the dollar is now past its peak. That is good news for the UK, as even a modest recovery in sterling takes pressure off energy prices and hence inflation. 

But there is also a growing mood – not yet a consensus – that while inflation will come down sharply next year, it will then become stuck. So we might get back briefly to something towards 2 per cent at some stage next year, but then inflation rises again and we are facing at least 4 per cent thereafter.

If this is what indeed happens it will be a global thing, not particularly a UK one, but that is no consolation. We will face the same grind as everyone else to push price rises back to an acceptable level, because all the major central banks made the same mistakes. 

We are not going to have those near-zero interest rates or the flood of money through quantitative easing ever again in our lifetimes. But we will pay the bill for those policies for some years to come. 

The bill comes in three stages. The first is over; we are in the middle of the second; and the third is to come. 

The part that is over is the surge in asset prices, with the more speculative the asset, the bigger the bubble. Those bubbles are popped. Wealth that was never really there at all has evaporated, as was always going to happen. 

Take crypto-currencies. The bubble is not completely deflated yet, but I agree with the European Central Bank staff members who wrote last week that Bitcoin was on ‘the road to irrelevance’ – though I thought their statement that, ‘Bitcoin has never been used to any significant extent for legal real-world transactions’ was a bit rough. 

We should feel sorry for the small-scale punters who have lost their savings but not for the sophisticated institutions which backed the movement, or indeed for the central banks which created the conditions that allowed the bubble to inflate in the first place. 

But that phase is over. What is happening now is the repricing of everything. You can see how that has begun in house prices here in the UK, now down three months running. It has happened to US high-tech shares, with the Nasdaq index down 28 per cent this year. It has happened to bond portfolios, where values are typically down by at least a quarter since January. 

The only assets that have not fallen are those that were sensibly priced back then. The FTSE100 index is actually up 6 per cent on where it was at the beginning of December last year. 

This repricing will continue, with different types of asset establishing what seems realistic and what is not. I am encouraged by the way the Footsie has performed, because it represents large solid enterprises that produce goods and services that people are always going to need. 

The fact that it is trading higher than it was a year ago, after what has been a pretty dreadful period, suggests that people have been able to make a common-sense judgment about the value of these large companies. House prices? Well, they will take longer to find a stable level after the rip-roaring ride of the past few years, but I don’t see a huge crash. People need homes. 

All this is predictable, broadly at least. What isn’t predictable is the third stage of this whole sorry story. That concerns how quickly inflation comes down, where it levels off, and what happens then. We are flying pretty much blind. It is not simply that the central bankers got their inflation forecasts so wrong. Hardly any of them have experience in their careers of what happens when inflation is in double-digits. 

This is why the growing fear that inflation may settle at around 4per cent matters so much. If that happens, then there will be huge pressure on the central banks not to be too tough. 

There will be calls for the target rate to be increased from 2 per cent to perhaps 3 per cent. Budget deficits will stay elevated. Labour tensions will grow. Politicians who try to increase taxes will get voted out, for the UK is not alone in seeing push-back against austerity. 

The 2020s may not be a social and economic catastrophe like the 1970s, but they will be a difficult, uncertain period for all of us. So let’s hope that these increases in interest rates, of which we will get more in the coming days, do indeed knock inflation firmly on the head.