Effects Of Inflation Are Here To Stay As Price Restraints Weaken
A Fleet Street Letter White Paper Report
By Brian Durrant
In the past, Mervyn King the Governor of the Bank of England, has described the process of setting interest rates in terms of the Maradona effect. He wasn’t referring to setting rates by illegal means or by sleight of hand, but in terms of his stunning second goal against England in 1986.
The great Argentinian footballer bamboozled the England defence by feinting one way and then the other while he himself proceeded in a straight line. The Bank of England performed a similar feat in between November 2001 and February 2003, when rates remained steady at 4%, while at various times the markets were looking for interest rate cuts or interest rate hikes. Again from August 2004 and August 2005 rates were kept on hold at 4.75% while from time to time markets looked for either easing or tightening.
Effects of Inflation: Bank of England now wrong-footed
Now it is easy to play the Maradona game when the risks of an economic slowdown or a pick up in inflation pressures are finely balanced. In other words when a feint left is just as likely as a feint right.
But in the last 15 months steering a steady course and managing market expectations has proved more difficult. In February 2006, the Bank expected inflation to spend most of 2006 at 2% and stay there in the medium term with a Bank rate at 4.5%. By May, inflation risks had mounted and a rate hike in August to 4.75% was agreed. By November, rates were raised again to 5%; the Bank signalling that would be enough. Hence the rate hike to 5.25% in January 2007 was a surprise. This February’s inflation report and the March inflation numbers made a further rate hike this month a certainty, while last week’s inflation report hinted at more rate rises to come. In the past year or so the Bank has tended to underestimate both the rise in inflation and interest rate response needed to quell it. This month’s May inflation report is a robust response to the challenges it faces.
In the May inflation report it said that if interest rates stayed at 5.5%, the Bank’s central forecast would be for inflation to be above target and rising sharply in two years’ time. So another rate increase is on the cards, certainly by August if not before. Furthermore, interest rates will keep rising beyond that until inflation is brought back to 2% and anchored securely at this level. In other words, the Bank is serious about getting inflation back under control.
Effects of Inflation: Don’t expect interest rate cuts this year
It follows that the Bank has made it clear that it will err on the side of caution. This is in spite of sharp falls in the headline rate of inflation due to come through. The 12-month increase in the consumer price index should fall back quite sharply over the next 6 to 12 months towards the 2% target and possibly below. This will reflect not only lower gas and electricity prices this year but also last year’s energy price hikes dropping out of the 12-month comparison. In the 12 months to March 2007 higher electricity, gas and other fuel bills rose by 24.9%, adding nearly one percentage point to the consumer price index. However, if you strip out utility prices, the CPI has risen from 1.2% in October 2006 to 2.1% in March 2007.
So news that the headline rate of inflation fell from 3.1% in March to 2.8% in April in no way prepares the ground for interest rates cuts in the foreseeable future. Underlying inflation pressures are still there. Of the 39 categories within the CPI, 24 have an inflation rate above the 2% target.
Effects of Inflation: CPI a flawed measure
To make matters worse inflation pressures could intensify because of a statistical quirk unique to Britain. In 2003, the Bank of England was reluctantly forced to change its target inflation rate to the Consumer Price Index, ostensibly to harmonise with Europe. It was introduced as Gordon Brown’s sop to Tony Blair when the Treasury rejected entry into the euro. Hitherto the retail price index (RPI) had been the main gauge of inflation in Britain for 50 years. Government departments, employers and trade unions still use it as a benchmark for setting wages, pensions and financial payments, like the coupon on index-linked gilts. Moreover, many believe that the CPI seriously understates the true cost of living in Britain because it excludes such crucial elements as council taxes and mortgage payments.
The problem is that in the past year or so the two measures of inflation have diverged widely with the RPI rate of inflation currently standing at 4.5% compared with the CPI rate of 2.8%. In October 2005, the RPI and CPI inflation rates stood at 2.5% and 2.3% respectively. Moreover, the expected fall in the CPI measure of inflation in forthcoming months, will not be matched by a similar decline in the RPI measure as the latter index will incorporate higher mortgage costs that are in the pipeline. Trade union bargainers and personnel managers are increasingly aware of the growing gap between the official inflation measure and the much higher inflation perceived by ordinary workers.
Rate of Inflation: Why pressures are growing
Indeed, if you look at the inflation picture in the medium term, many of the restraining influences on inflation enjoyed in the last 10 years are starting to dissipate. The high streets and industries of Britain may be more intensely competitive than they were in the 1970s and 1980s but surveys show that business managers now feel more freedom to raise prices than at any time in the past decade. A point emphasised by our retail expert Glynn Davis towards the end of last year.
Meanwhile, the influx of immigrant workers may be peaking, while the cost of Chinese goods is starting to rise and will do so markedly if China eventually revalues its currency. At the same time the outlook for global growth is quite robust. By the end of 2008 the US is expected to emerge from its housing market inspired dip, Germany is re-asserting itself as the locomotive of Europe and Asia continues to experience explosive growth. All things considered the risks to inflation in the medium term remain seriously on the upside and the Bank of England acknowledges that.
So those expecting interest rates to fall as headline inflation falls this year will be disappointed. Interest rates will certainly rise further and, more importantly, stay high for a protracted period, leaving the markets to feint one way and then the other. Cheap money is a thing of the past just as someone takes over from Gordon Brown at the Treasury!
Brian Durrant is the Investment Director of The Fleet Street Letter.
First published on May 26th 2007
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