News that consumer price index inflation remains above target suggests there are risks to the Bank of England’s apparent position that deflationary forces will start exerting themselves.
The index remained flat at 3.1 per cent over August, still 110 basis points above the bank’s target. Retail price index inflation slowed marginally from 4.8 per cent to 4.7 per cent over the month.
Most worrying about the inflationary overshoot is that it eats away at arguments put forward by bank governor Mervyn King that the high figures are the result of one-off factors that should ease. Their persistence, however, suggests that Britain may be stuck with above-target inflation for longer than anticipated.
Chartwell Investment Management head of fund research James Davies says: “Inflation is more of a threat than deflation. With the level of stimulus we have had and interest rates being where they are, I favour the inflationary camp. We are also vulnerable to imp-orted inflation.”
The impact of this could be felt most sharply by investors in government bonds, with UK 10-year gilts yielding 3.06 per cent and US treasuries yielding 2.71 per cent as at September 14. In real terms, bondholders will see their capital eroded as price inflation outpaces income at current levels.
Higher than expected inflation will also restart the discussion on the delayed effects of quantitative easing and the wisdom of rock-bottom central bank interest rates if the prospects for an inflation spike start growing.
Ashcourt Rowan head of research Tim Cockerill says: “It is a complicated picture. Looking at the broad spectrum of investors, many are simply are not focused on inflation. Nobody in the UK can have escaped Government negativity with cuts imminent and this has meant people are happier to hold cash and gilts.”
There can be little doubt that incidents such as the forest fires in Russia – which led to a ban on grain exports from the country – helped push up the cost of staples such as bread and cereals. Alone, however, they are not enough to explain rises elsewhere in the costs of air travel and clothing, for example, that also saw price boosts over August.
Most worrying for the Adviser Fund Index panellists is that the bank will jump on the quantitive easing bandwagon even while the trajectory of core inflation remains uncertain.
Davies says: “The discussion of a double-dip recession is a bit of a red herring. It is a statistical factor but the reality is over the next five years growth is going to be slow, according to the bank’s own forecasts. What might now be possible is that we could see a period of slow growth but with strong upward pressure on inflation.”
Even this is far from the worst-case scenario. The problem with a discussion of a double-dip is that it presupposes a W-shaped recovery, with an economic dip easily outdone by a subsequent recovery.
With the Government set on a programme of sharp public spending cuts there is the risk of a permanent destruction of capacity. Not only would this imply lower living standards than in the recent past but it would also put a cap on long-term growth prospects if the public become convinced that consumption is inherently the wrong course.
For the moment at least, bond markets appear to be siding with King in predicting strong downward pressure on inflation. If they are wrong and inflation spikes upward, buying into low-yielding government paper could prove a hugely costly decision. However, if they are right in thinking the UK could suffer a bout of deflation and be pushed into another recession, the outlook for most asset classes is pretty dire.