Compound interest

Inflation: the evil twin of compound interest

MoneyWeek turns 21 in early November. It has been a busy twenty years. We’ve been through the dotcom bubble, two commodity supercycles, the housing bubble, a once-in-a-century financial crisis, and a once-in-a-century pandemic.

In short, we circled the block longer than a traffic cop in London. But one thing we haven’t experienced yet: bad inflation. I wonder if we will now.

Inflation not so transient

John details why we’re concerned in this week’s magazine, but the bottom line (which is rapidly increasing) is that all the signs are there. The massive printing of money, which this time goes directly into the system rather than plugging holes in banks’ balance sheets as in 2008-2009. Supply bottlenecks, skills shortages and rising commodity prices – a combination that points to a wage-price spiral. And, last but not least, central banks and a majority of economists insist that inflation at multi-year highs is transitory. It would be the same central banks and the majority of economists who did not see the financial crisis coming.

It may not be long before we start noticing that the prices of the items we buy on a regular basis go up. We all have our own daily inflation gauges. Mine is the Peppermint Aero. I remember a bar costing me 22p in 1988. Now it sells for 60p. The Bank of England’s inflation calculator, by far the most interesting thing on the website, suggests this is true: £22 in 1988 was £60 in 2020. Prices have almost tripled.

The average annual rate since 1988 is 3.2%, which is not too bad. But apply that for 33 years and watch what happens. Push it up to 5% and silver depreciates much faster. At this rate, £100 shrinks to £36 in 20 years. Inflation is the evil twin of compound interest.

So keep an eye out for your favorite brand of cereal, chocolate bar or wine. Also beware of “shrinkflation”. Sometimes the price remains the same but the package becomes smaller. I seem to remember the 1988 Aero bar being a bit longer. I couldn’t swear to it, but I know for certain that just a few years ago Cadbury was selling six creme eggs in a pack; now there are five.

Where does all this lead (beyond creme eggs in packs of four)? It is becoming increasingly clear that central banks have no intention of pushing inflation out of the system. They have subtly raised the bar of what they say they need to see or anticipate from inflation before they stop printing money via quantitative easing or raising interest rates. We repeatedly hear that inflation should be temporary, and they will ignore it. They suggest they will tolerate above-target inflation for longer than in the past. This spring, the US Federal Reserve changed its official inflation target from 2% to an “over time” average of 2%. Two weeks ago, the European Central Bank also raised its inflation target. It is now targeting inflation of 2% over the medium term, whereas it previously struggled to keep inflation below but close to 2%.

Interest rates cannot rise

The direction of travel is clear. The goal is to inflate the world’s huge indebtedness – largely caused by central banks keeping interest rates too low for too long, of course. A sharp rise in interest rates would paralyze the global system.

Bond yields remain historically low as investors apparently assume that the disinflationary environment of the past 40 years will last indefinitely. And central banks have been buying up much of the bond market with printed money, which is also keeping yields low. The result ? We are in years of below inflation returns, which is great news for gold. If rates end up rising in an environment of out-of-control inflation, that will also benefit. I’m going to top up my gold today – as soon as I finish my 60p Aero.