Inflation to fall sharply (perhaps)

Stop press. It is reported that Salis Grano Mega Holdings has lent the UK government 1 milllion pence in a special 5 year cash for certificate swap arrangement that will see the renowned London financial house benefit to the tune of RPI + 0.5% per annum over the term of the deal. An SGMH spokesperson said that the flexible nature of the arrangement, with no exit fees after the first year, would benefit both parties. However, an anonymous insider noted "As ever, SGMH is behind the times on this one and in order to benefit will need to lock up capital at a time when there may be better opportunities elsewhere. HMG will likely be the winner. When SGMH moves, be sure to jump the other way." The Bank of England refused to comment on the deal.

Well, I dunno. An index-linked cert looks such a dead cert that you'd have to be certifiable not to want one. All the newspapers and PF bloggers tell me so. Even the Building Societies recommend NS&I, so like many other savers I've claimed my taxpayer subsidy. Inflation in the short term is a concern but I am not so concerned in the medium term. Like the hyponchodriac who tells you he is going to die, Mervyn King will be proved right, someday. In a three years time we may be looking at tumbling inflation and soaring interest rates. However, the long term is a different matter. This could be scary. In the meantime, my asset allocation has now shifted slightly towards the risk-averse. The ILSCs are included in my "State" category. This does not include Gilts, though, which I would class under "Bonds", if I had any.

There are clouds gathering on the far economic horizon. Globally, commodities, food and water have seen, and will see again, stresses in the demand and supply chain. Fundamentally, however, there is no problem per se. There is no shortage of any of these . . . that the application of energy can't fix, but that, indeed, is the problem. Almost all commodities and resources are wonderfully abundant in physical terms when compared with our actual consumption, but abundance does not imply easy availability.There is always a price to be paid and ultimately that price is energy. We could, for example, green the Sahara and double our food supply "simply" by desalinating the North Atlantic and, in the process, produce so much gold that everyone in the world could have their own 100 gram bar, worth about £3000 at today's price, except of course that such a valuation would be utterly destroyed, as would central bank reserves. It would be a strategem to rival that of a Bond villain:

but, without some Vogon-like scheme to channel a few spare zettajoules of energy down to Earth, it would be even less likely to succeed.

Smith, Ricardo, Marx et al. sought to identify the source of economic value. As far as they could see it was human labour. A good guess, but it failed to account for our then burgeoning ability to release the fossilized energy of ancient sunlight. The idea of "value" has little value, I suspect, in today's economics, but if it did, it would surely be based on energy. Our ability to source, channel and apply energy underpins all human activity and determinations of economic value, and the fact that, over the past two centuries, we have been raiding the store cupboard without restocking it, is our major long term problem. Don't worry about AGW, by the way, we can simply shade the Earth, extract CO2 from the air, compress it  and propel it into Deep Space. With sufficient free usable energy, all most things are possible.

But the problem is, it takes energy to get energy, and the energy cost of getting energy is rising. Silicon dioxide, for example, the source material for photovoltaic cells, is everywhere (it's sand) but fusing it into ingots and processing it into wafers on an industrial scale takes gigajoules, and gigajoules cost serious wonga. It's the same story for all the alternative energy sources if they are to be made both reliable and safe. Only when the price of fossil fuels rises sufficiently can alternatives to them become economically viable. The good news is that the long term future of alternative energy is assured. The bad news is that, after any medium term drop, so is the long term future of inflation (helped by governments' addiction to deficit financing). A corollary is that rising energy costs will tend to depress long term growth, as will the projected population maximum of 2050-2100.

But what does this mean in practice? It means different things for different people, of course, depending on their wealth and lifestyle. The poor (waged and unwaged), as usual, will take the major hit, since they have less discretionary income with which to buffer price rises. The wealthier employed, those in the upper two deciles, will do best, since they probably have the market muscle to maintain their income in real terms. In other words, inflation is one of the causes of wealth polarisation, so it will be up to governments to fight this one way or another, if they can or, indeed, if they want to. Also benefitting will be the indebted, but I really, really would not recommend that as a way to beat inflation.

What will it mean for me? This is a question that everyone needs to ask since we all have our individual rates of inflation. For your humble author there is, fortunately, a certain amount of leeway, for a while at least. The Grano household, which contains four members, has outgoings of roughly £2000 per month. At the moment this is easily covered by income, but in a couple of months this will no longer be the case as I wave goodbye to my salary and hello to my pension. It seem a good time, therefore, to examine the household budget. The breakdown would seem to be as follows (apologies for any wiggly formatting):

Food, drink and houshold      25%

Saving                                 23%

Housing                               16%

Energy                                  5%

Utilities                                 4%

Clothing                                3%

Granuli                                  3%

Essential travel                      3%

Insurance                              2%

Charity                                  1%

Recreation and Misc              15%

Total                                   100%

It should be obvious that there is a margin of safety here and that there is scope for cutting. Firstly, savings can be cut and, indeed, will necessarily be reduced when an old endowment mortgage expires in two years time. Secondly, the current repayment mortgage could be paid off, if desired, and that will cut the housing component in half (the other half being Council Tax). These two cuts together would reduce the expenditure by nearly 30% without any immediate lifestyle change. Thirdly, the recreation and miscellaneous category could be pruned, as could the food budget. This might yield a further 10% reduction before family rebellion sets in. From there on, things get tougher.

However, even a 40% cut is pretty severe. What would it gain? With inflation at 5%, I reckon about ten years, since by that time the new budget of £1200 would have grown back to nearly £2000. After 30 years (let's look on the bright side) it would be over £5000. If long term inflation were to be 2% lower that figure would be £2900, whereas if it were 2% higher it would be £9100. That's a huge disparity for relatively small (yet historically common) variations in the inflation rate. Unfortunately, a 2% discrepancy, either way can soon emerge as you can see from the notorious Bank of England fan chart:

The point here is not whether the central tendency is correct, but the rapidity with which the forecasting error emerges. Now that the BoE has more or less abandoned the CPI target of 2% we can expect this error to be on the upside. I'm not a hyperinflationist, but then I don't need to be in order to be concerned, since "normal" inflation is quite bad enough if it constantly overshoots. At some point interest rates will rise and we will have the strange phenomenon of falling CPI but differentially increasing RPI. Since, by government edict, benefits and pensions now rise only by CPI or thereabouts, it's going to be a jolly time for anyone with a big mortgage and a CPI linked income.