Inflation, interest rates and government spending – what’s the latest?

There are two big questions hanging over financial markets. “Is inflation taking off?” and, “when will central banks and governments start to slow or withdraw their stimulus measures and raise interest rates?”.

Judging by what has emerged from the meeting of G7 leaders in Cornwall and the latest statement from the US Federal Reserve, the current answers to these questions are “yes, temporarily” and “a bit sooner than we thought a few months ago”.

What’s the latest on inflation?

The evidence of a spike in inflation is mounting as economies recover from the coronavirus pandemic. But supply bottlenecks have yet to clear. In the UK, the Office for National Statistics said it rose to 2.1% in May, above the Bank of England’s inflation target and up from 1.6% in April.

Last week, the US Labour department said that consumer price inflation rose 5% in the year to May, the largest increase since August 2008. The prices for major household purchases, such as cars and furniture, jumped especially quickly.

Economists who believe the spike in inflation is temporary might be right. For instance, commodity prices – lumber, copper, corn – have all fallen back from their highs in the last month as bottlenecks clear and new supply comes on stream.

But the price of the most vital commodity, oil, continues to climb. The benchmark price of a barrel of Brent crude is up 43% to over $72 since the beginning of the year. Past performance is not a guide to the future.

Will interest rate rises follow?

The US Federal Reserve subtly shifted position this week. Its interest rate setting body, the Federal Open Markets Committee, said it still expected the spike in inflation to be temporary so that inflation will average its 2% target over time. It maintained its target Federal Funds rate at 0.25%.

However, it released economic projections from its officials, which forecast accelerating economic growth this year and shows most of them now expect two rate rises in 2023, a year earlier than previously thought. This was the equivalent of giving a little touch on the brakes, illuminating its taillights for a moment so those following could see it is watching the road ahead.

What about further government support?

There was a slightly different message from G7 leaders, who are responsible for fiscal (government spending and taxes), as opposed to monetary policy (interest rates and money supply).

The leaders, including President Biden, said: “We will continue to support our economies for as long as is necessary, shifting the focus of our support from crisis response to promoting strong, resilient, sustainable, balanced and inclusive growth into the future. Once the recovery is firmly established, we need to ensure the long-term sustainability of public finances to enable us to respond to future crises and address longer-term structural challenges, including for the benefit of future generations”.

What does this all mean for investors?

Investors face two possible scenarios. First, with inflation spiking and the continued pumping of money into the economy, the outlook for shares remains supportive in the short term. But they should be prepared for the pace of stimulus to slow, which is likely to affect market sentiment and market valuations.

Or, alternatively, there is a risk that the inflation spike turns out to be more permanent, because the supply of cheap money from central banks and generous public spending from governments goes on too long. There is also the possibility of another jump in the price of oil if producers fail to pump more barrels.

If inflation becomes embedded in the system, then households and companies could adjust their inflation expectations and build rising prices into their assumptions, creating a vicious circle.

Andy Haldane, the outgoing chief economist of the Bank of England, is clearly worried about this scenario and recently wrote an opinion piece entitled “The beast of inflation is stalking the land again.”

If this second, worse scenario comes about, the powerful central banks, including the Bank of England, could be forced to raise interest rates abruptly, bringing the economic recovery and markets to a shuddering halt.

It is therefore welcome that the signals from the US Federal Reserve showed it was alive to this risk and prepared to act pre-emptively.

Investors should keep a cautious eye on the situation and hope that central banks act in a timely fashion, neither too soon nor too late. That would be by far the least harmful route for them to take.

This article isn’t personal advice, if you’re not sure what’s right for you, seek advice. All investments fall as well as rise in value, so investors could get back less than they invest.

George Trefgarne is CEO of Boscobel & Partners, a political consultancy. Hargreaves Lansdown may not share the views of the author.

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