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Under the influence of inflation

Simon Brett, head of investments at Parmenion Fund Research, considers the inflationary factors in the UK and the uncertain prospects for trying to control any rise

Recent forecasts for inflation have been consistently wrong in the UK. The consumer price index measure of inflation has not been below 3 per cent since December 2009, which is above the Bank of England’s target for an annual rise of 2 per cent.

Does this mean that the UK has a structural inflation problem, and, if so, what are the policy remedies?

Here, I will consider some of the well known causes of UK inflation and ask what is now driving the numbers upward, what may happen in the future and what does that mean for interest rates?

First, it is worth pointing out that a couple of years ago at the height of the financial crisis there were worries that deflation may take hold in the UK and the US.

In response, both the UK and the US began a technique of stimulating growth called quantitative easing as interest rates could not be lowered from their already historic lows. By, in effect, printing money, both countries wanted to induce a certain level of inflation into their economies to avoid Japanese-style deflation, a situation that has not been seen in the UK since the 1930s.

The forces driving up commodity prices are unlikely to end any time soon and perhaps this fact alone will result in structurally higher inflation

The tools to combat inflation are well known, whereas, as Japan has discovered, deflation can become a deep-rooted economic malaise with no obvious remedies. Although recent inflation has been higher than the Bank of England rate, compared with the 1970s, today’s inflation looks timid.

Then, the oil price crisis and high wage demands were the drivers of an average inflation rate of 13 per cent a year and 25 per cent in 1975. Forty years on, it is unlikely that excessive wage demands will drive inflation upwards. Unemploy – ment is at around 2.5 million and this is likely to keep a lid on wage demands.

Interestingly, it has been a feature of the current recession that employees have probably sacrificed a rise in wages to keep their jobs. Furthermore, with the expected redund – ancies from the public sector, the trend of subdued wage demands is likely to persist. However, what may be a repeat of the 1970s is a secular rise in commodity prices, and not just oil. The commodity super-cycle is one of the major investment themes of the past few years.

After a 20-year bear market that began in the early 1980s and lasted until the turn of the century, prices have been on the up. The continuous commodity index (a broad measure of commodity performance) has risen by over 40 per cent since 2002.

Many forecasters expect this trend to continue, with talk of a 20-year super-cycle. If this is correct, then there is another 10 years to go in this cycle.

The reasons for the increase in demand are well known and indicate a growing population in the developing world that aspires to a Western standard of living. This is good news for resource-rich countries like Brazil and Australia BUT it may be less comfortable for an open economy like the UK.

Whether it is soft commodities such as corn or hard commodities such as copper, if the rise in commodity prices continues, this will be a source of inflation beyond the control of the Bank of England.

In the past, the developed world was the major source of demand. Now it is the emerging markets and it is their demand that is more influential on prices.

Allied to this is the sterling exchange rate. As commodities are priced in dollars, the sterling exchange rate versus the dollar is important and can help/hinder the inflation rate.

From 2000 to 2007, sterling strengthened against the dollar (from $1.48 to $2.11) and this helped to mitigate some of the commodity price rises. Since then, sterling has steadily weakened against the dollar and is now at around $1.58. Although this will help exports, the import costs of dollar-denominated commodities will rise.

As the spectre of higher inflation looms, the amount of spare capacity in the economy and its interaction with inflation is interesting.

The Bank of England expects that, with the return of economic growth, inflation will be subdued.

The argument runs that output can rise to meet increasing demand, with labour being re-employed and factories/offices being reoccupied, so rents and labour costs will not rise.

However, some capacity will have been lost forever, whether it is factories demolished or the loss of workforce skills through unemployment.

When demand picks up, the economy may run into bottlenecks sooner than expected and it should be noted that measuring spare capacity is difficult.

Perhaps the Bank of England should not depend on spare capacity to keep a lid on inflation as its effect may be less than expected.

It is clear there are some constituents of inflation that are within the control of the Bank of England and some that are not. If inflation rises as a result of demand not being met by domestic output or rising wages, then interest rates can be raised to cool demand.

However, raising interest rates may damage an already fragile housing market and dent consumer confidence, perhaps hindering the recovery and even pushing the economy into a double-dip recession.

On the other hand, the expected upward trajectory of commodity prices in the future may cause longterm problems.

The forces driving up commodity prices are unlikely to end any time soon and perhaps this fact alone will result in structurally higher inflation.

Looking ahead, the target rate of inflation itself may have to be raised from the current 2 per cent to a level that is perhaps more realistic.

The make-up and path of inflation is complicated and it is no surprise that accurate forecasts are elusive.


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