23/05/08
Inflation Risks
Many households are understandably worrying about how to pay for higher petrol and food prices. How the Government and the Bank of England respond to these trends will have even more important implications, both for day to day finances and for financial markets in the UK.
Historians may well look back on the middle week of May as the start of a new era. On successive days, announcements were made which surprised or worried many commentators. The first was the Chancellor's statement that he was borrowing £2.7bn to pay for the 10p income tax package. This reignited long standing criticism from many economists about the rules created by the Treasury to control public sector finances. Even at the time of the March 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, which of course undermines their very credibility.
The chickens quickly came home to roost, when 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? So far the Treasury has not replied!
The following days saw worrying announcements about headline inflation, firstly that food and fuel costs had driven the CPI to 3% a year in April, secondly that the Bank of England expected further acceleration towards 3.75% pa this autumn. Hard on those heels, more stockbrokers forecast inflation could peak at 4.25% pa in coming months, taking account of expected gas and electricity price hikes by the utilities.
How worried should we be? The good news is that this state of affairs need not last long, depending on three key assumptions. The first would be that raw material prices do not head significantly higher, the second that the UK economy slows noticeably into 2009. Indeed the Governor of the Bank of England stated 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 late 2009, and investors can breathe a sigh of relief.
If these assumptions prove faulty, investors must expect volatile markets, for example if companies report a major squeeze on profits as they are unable fully to pass on those higher costs. More importantly, considerable pressures are building up on the government after the events of the past few weeks. The detailed 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, now by the 'stagflation lite' environment. The most worrying outcome would be if 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, 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. Financial markets are priced for a low inflation world, not for one in which inflation becomes much more volatile.
Andrew Milligan, Head of Global Strategy at Standard Life Investments
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