05/06/2008
Perspectives - May 2008
Key decisions in inflation lie ahead
How much faith do we have in policy makers in the UK? That question may seem rather academic or even off-putting for many readers, but the answer could have significant implications for anyone with a building society account, a unit trust, a pension or other investments.
The middle week of May was, at the very least, a fascinating one, at worst the start of a new era. On successive days, announcements were made which surprised, often worried, many commentators and economists. The first was the Chancellor’s statement that he was borrowing £2.7bn to pay for the 10p income tax package. The decision was clearly made ‘off the hoof’, outside the normal Pre Budget and Budget Report cycles. In addition, many economists have had long standing concerns about the rules created by the Treasury supposedly to control public sector finances. Even at the time of the Budget, government borrowing was threatening to break through the official ceiling. A further £2.7bn would certainly do so – unless the government re-jigs the rules quite materially, which of course undermines their very credibility.
The chickens quickly came home to roost. Shortly after the Chancellor’s statement, public sector unions raised the inevitable question: if the government can borrow for a tax cut, why not borrow to raise public sector wages, when many of its members face a significant squeeze on their wallets from rising food and fuel costs? So far the Treasury has not replied!
That issue leads onto the second announcement which shocked economists – that CPI inflation had reached 3% a year in April, just 0.1% away from the edge of the official target, and well above forecasts from City economists which had been closer to 2.5% a year. The third announcement followed hard on its heels – the Bank of England’s Inflation Report, admitting that CPI inflation might reach 3.7% a year by the autumn. Stock brokers hurriedly re-calculated their figures, taking account of a likely 15% or so rise in gas and electricity prices scheduled for this autumn by some of the large utilities. The highest estimates – so far – are that CPI inflation could reach 4.3% a year, over twice the official target! Of course, the Bank forecast that inflation would fall back to target in two years time, but it had to or otherwise the implication would be that it should tighten, not ease, monetary policy in coming months.
Will this be a summer sensation? The good news is that this state of affairs may not last long, depending on three key assumptions. The first would be that raw material prices do not head significantly higher from current levels, and there is some evidence that the latest moves up in some commodities are largely driven by speculative activity and momentum trades which could quickly unwind. The second assumption is that the UK economy slows noticeably into 2009; indeed the Governor of the Bank of England did state that the UK might see one or two quarters of negative growth, a most unusual warning from a central bank governor. Finally, labour markets must remain flexible, keeping wages under control. On this basis, then CPI inflation should roll over, back towards target during 2009, and investors can breathe a sigh of relief.
If these assumptions prove faulty, investors must expect volatile markets. For example, one of the Focus on Change questions we ask is ‘what is priced into the markets’. Analysts still expect significant profits growth into 2009, and a squeeze on margins, where companies cannot pass on much higher raw material costs, would come as an unpleasant surprise.
Much more importantly though considerable pressures are building up on the government after the events of the past few weeks. The regulatory, fiscal and monetary policy framework, which was put into place about a decade ago, has begun to be severely tested, first by the credit crisis, then by the combination of economic events leading to a ‘stagflation lite’ environment. Some improvements to the framework would be welcomed by investors, but there is a clear danger that the baby gets thrown out with the bath water. The most worrying outcome would be that the government concludes that the best way to deal with a period of higher than expected inflation, especially inflation generated by events outside the UK affecting global commodity prices, would be by changing the Bank of England’s inflation target, say by widening the band from 1-3% to 0-4% a year. Signs that public sector wage awards were responding to the rise in headline inflation, with further easing of the borrowing rules, would be another unfortunate decision. Any short-term political benefits must be set against the long-term pain which would result if serious questions were asked about whether the UK can remain a low inflation economy.
Andrew Milligan, Head of Global Strategy at Standard Life Investments
This was published in Investment Adviser on 5th June 2008.
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