Get set for index gilts if inflation takes off

11 December 2009 8:00 am

During the financial crisis last year, there was much talk about deflation as output fell and parts of the banking system nearly failed.

With an enormous stimulus from many central banks, the worst seems to have been averted. Perhaps a sign that things are returning to normal is talk that inflation may be become the problem again rather than deflation.

Those with a long enough memory will recall that in the 1970s, inflation was one of the major economic problems.

The Bank of England has the specific remit of targeting inflation, which perhaps demonstrates the role that inflation has played in the economic psyche of the country. But if inflation is back on the agenda, an interesting question is raised, is it the right time to buy index- linked gilts for protection?

In this article I will examine some of the possible causes of inflation and assess their likely impact in the near future.

Current forecasts for inflation are relatively benign. The Bank of England expects consumer price inflation to rise from 1.1 per cent currently towards 3 per cent in 2010 as the cut in the VAT rate is reversed and higher petrol prices feed through to the forecourts. The expectation is then for inflation to fall towards the target of 2 per cent over the next two years.

One of the reasons the bank cites for the subsequent fall is the amount of spare capacity in the economy, often referred to as the output gap.
The expression output gap is a polite way of describing assets in the economy which are inactive. During contractions/recessions, people lose their jobs and factories and office space are left empty as the demand for their output is simply not there. This leaves slack that may be taken up again when activity picks up. The unemployed will find jobs and plants will be brought back into use.

There is no problem with the issue of sufficient resources meeting the pick-up in demand, as it will take time for this surplus capacity to be used up. Inflation only becomes a problem when the increase in demand exceeds the available capacity to meet that demand and scarce resources are bid up in price, whether that is for labour, land, materials etc.

Given the dramatic fall in activity last year, inflation from this source would not appear to be a problem for some time.

However, measuring the output gap is notoriously difficult. Some of the productive capacity of an economy may be lost forever and with it the associated skills. Therefore, forecasting how and when the closing output gap may begin to cause inflation is also difficult.

Perhaps the best anecdotal measure is to watch for signs that employers are finding it difficult to find labour and earnings begin to rise. Rising wages can cause inflation.

However, so far, in this recession, wage flexibility has been prominent, trade unions have not been as powerful in the private sector and wage freezes have been more the order of the day, helping employers to control costs and employees to retain their jobs.

One increase in price that will not have escaped the attention of many people is the increase in the price of petrol and commodity inflation in general. After dramatic falls in the price of commodities during the credit crunch, prices this year have been rising.

Take oil and copper, for example. The price of the former has risen from $50 to $80 since the beginning of the year. The strength of sterling against the dollar has helped to mitigate some of the effects but that will be of little comfort to the hauliers who may try to pass on the increased costs. Likewise, high-grade copper, used in many industrial processes, has gone up by 100 per cent during the same period.

Various reasons have been brought forward to explain the recent rises, from Chinese stockpiling to the buying of commodities as an investment, however, its impact in such an open economy as the UK will not be helpful.

Given the difficult economic backdrop, company margins will probably take the brunt of the rises, but this will not last forever and eventually producers may try to pass on the higher prices. All the above, at various times, have been a cause of inflation in the UK.

More recently, the Bank of England has also embarked on quantitative easing. Since March this year, the Bank of England has been buying gilts from banks and other institutions. The sellers of the gilts receive monies as payment on which they will earn very little return, given the extremely low interest rates on offer.

Rather than earn a miserly return on cash, it is hoped that banks in particular will seek higher-yielding lending opportunities, thus, companies and individuals will be encouraged to borrow and spend, setting in motion a virtuous circle of demand for goods and an expansion of output.

To date, there is little sign that this is beginning to happen. Instead, assets and the stockmarket have so far only benefited, rising in price from their trough in March of this year. This will make it especially tricky for the Bank of England to withdraw the monetary stimulus. Too soon and any nascent recovery may falter. Too late and the money supply growth may get out of hand and fuel inflation.

It is the effect on the money supply via QE and its inflationary consequences that concerns some commentators.

With all the money now being pumped into the economy, not only in the UK but also in other major economies, some monetarists now think it is only a matter of time before inflation takes off.

Monetarists believe that an increase in money supply leads to increased spending. Should the supply of goods/services not be able to meet that demand, then prices will be bid upwards.

The rise in demand may also lead to imports rising if the domestic economy is not able to meet that increased demand. With more sterling on the foreign exchange markets, any weakness may lead to imported inflation as the price of imports goes up.

Opinion is divided as to whether QE will spur inflation. The latest member of the monetary policy committee, Adam Posen, recently said that there is no evidence from history that QE will lead to inflation.

Many of the current forces that will determine the outlook for inflation in the near term are inter-related.

For example, with more spending from an increase in the money supply, the output gap may be closed quickly. As demand picks up, employees may want to recoup some of their lost spending power of the past few years.

At present, some of the above forces are benign for inflation, such as wage growth, and some less so, such as commodity prices.

Should the present balance begin to shift, index-linked gilts are likely to move up the agenda for investors.

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