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Equities remain favourable as deflation looms

Inflation could quickly spike once the effect of the tumbling petrol price falls out of CPI calculations if the Bank of England is not careful, experts warn.

BoE Governor Mark Carney’s delivery of the latest Bank of England inflation report that confirms deflation is looming, but likely to be short-lived, equities remain the most promising asset class for investors.

Carney’s more hawkish stance suggested that low inflation could last longer than predicted, with negative inflation a distinct possibility.

Whereas the Monetary Policy Committee previously expected inflation to trough at 1 per cent in the first quarter, now it expects inflation to average 0 per cent in the second quarter, saying: “It is now more likely than not that CPI inflation will dip briefly below zero at some point in the first half of 2015.”

As this risk becomes more persistent, Carney said the MPC would consider another round of quantitative easing or a further cut to the base rate.

Royal London Asset Management chief economist Ian Kernohan says the recent disinflation is driven by the oil price slump and the delayed impact of stronger sterling last year.

He thinks falling price levels is transitory.

Once the precipitous fall in the price drops out of year-on-year comparisons it could cause a rapid increase in inflation.

“The Bank of England pushed back on market expectations that interest rates will remain on hold until late 2016,” he says.

“Cheaper energy is actually a reflationary impulse further out, and once the oil price effect drops out of the year on year comparison, the headline rate of inflation should rise quite rapidly, albeit from a very low level.

“The bank feel[s] that slack in the economy has continued to fall and now accounts for just 0.5 per cent of GDP.  Of course there are risks and interestingly the bank have now opened up the possibility of Bank Rate falling below 0.5 per cent, should prospects for the economy deteriorate.”

Aegon UK investment director Nick Dixon says while the BoE may not be showing concern over stalling inflation, there are sufficient grounds to consider an interest rate cut, despite low food and oil prices.

“The threat of deflation, together with sterling’s gains against the euro, have created an unexpected challenge for the BoE, and we could see a 0.25 per cent interest rate, and even a reinjection of quantitative easing, before the year is through,” he says.

However, a robust UK economy and a slowly recovering oil price suggest a deflationary period would be temporary, recovering in the second half of the year.

While the declining oil price is largely to blame, Capital Economics chief UK economist Vicky Redwood says: “In fact, the fall in oil prices and market interest rates has prompted the MPC to revise up its growth forecasts from next year. Its forecast for this year remains at 2.9 per cent and next year’s forecast has been revised up from 2.5 per cent to 2.9 per cent.”

But The Share Centre has downplayed the impact of the report.

Investment research analyst Helal Miah says: “This inflation report does not signal any major changes from what we already knew. Therefore, in this environment we feel that the equity market still represents the most attractive asset class for investors. This is due to good real incomes and the prospect of capital growth, as the economy continues along the path to recovery.”

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