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Inflationary pressures?

1/11/2016

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They said it was going to happen and it did.  Inflation ticked up to 1% this week, slightly ahead of expectations. It was driven by higher clothing and fuel prices, but not – as expected – by weaker sterling. The bad news is that is still to come. It makes for a different environment.

For some time, the risks have been of deflation and that has supported the price of government bonds.  After all, negative yields could make sense in a climate of falling prices.  However, it reduces the real return of bonds still further, making them a toxic investment for the longer-term.

It is a reminder that interest rates do not have to go higher for bond yields to rise.  There are myriad influences on bond yields of which interest rates are only one part.  The 10-year gilt yield is already around 0.5% higher than its level at earlier this year.

It is also a reminder of how uncomfortable inflation feels.  Who knew that a pot of Marmite could be vulnerable to the weakness of sterling?  Yet it effectively illustrates the extent to which consumer goods, even the most apparently ‘British’, have global supply chains.

Although those in favour of a ‘hard’ Brexit have been quick to champion the low pound’s boost for exporters, they have been slower to defend its impact in the pocket of consumers.  Inflation takes money directly out of the pockets of shoppers, arguably a far more important part of the UK economy than exporters.

None of this is particularly catastrophic in itself.  It is simply a drag on already weak growth. It is likely to revive the problem of the ‘squeezed middle’ so popular around election time, where families increasingly see their disposable income slide. Nevertheless, its effects on inflation figures are likely to be temporary and it may even encourage people to buy British.

Unless it gets really bad, it is unlikely to prompt action by the Bank of England.  Governor Mark Carney is likely to continue to ‘look through’ this spike, as its effects on inflation figures should be temporary.  Raising interest rates in response could really hurt the UK economy.  However, even though a rate rise remains unlikely, it is an uncomfortable environment for the bond markets.

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    Author

    Director, David Hardman has over 20 years experience in financial services.

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