20 October 2016
The inflation genie emerges
How serious could UK inflation get and what can we do about it?
by Frank O’Nomics
Be careful what you wish for. After years of effort from the Bank of England to get inflation to return to their long-term target of 2%, it finally seems that price pressures in the UK are picking up. This should come as no surprise after a fall in sterling that, in traded-weighted terms, amounts to over 18% this year; 16% of which has occurred since the Brexit vote. This cannot fail to have an impact on the costs of goods and services to UK consumers. A number of factors will be key in determining how far prices here will rise, but the key issue is the extent to which the move will have an impact on real disposable incomes. Clearly, if wages and savings rates rise at a faster pace than inflation then we should be little concerned by a pick-up in prices, after all, this is what the MPC has been striving to create for a long time. We must ask whether the pick-up inflation is going to be good or bad for us, and consider whether there is anything we can do to mitigate the negative effects.
How bad the situation is the inflation outlook? The UK consumer price index picked up from an annual growth rate of 0.6% in August, to 1% in September, the first time it has been this high since November 2014. This is still not a huge number, and clearly well below the 2% target. The problems are that the figure is greater than expected, and has occurred for reasons other than the recent decline in sterling. Clothing and footwear together with fuel were the main drivers of the increase, largely due to discounting last year dropping out of the calculation. That means that we still have the impact of the fall in sterling to come. Working out how much of the rising cost of imported goods gets passed on to consumers is not easy. Retail price margins may be able to take some of the strain and, given a high level of competition, many retailers may be prepared to suffer lower profits to retain or build their market share. ,However, excessive competition has meant that margins are already pretty skinny and the element of “pass-through” of input cost rises is likely to be high. There is also an opportunistic impact coming from domestic producers who, having seen the competitive advantage derived from not being subject to rising import prices, are able to put their prices up without a loss in volume. This has been particularly evident in the movements in prices of domestically produced meat, which have broadly gone up in line with imported meat for no reason other than a profit motive.
What this means for inflation will depend on whether the recent fall in sterling is sustained, reversed or extended. If we see the currency stabilizing at current levels the fall so far is likely to put prices up by around 6% or so over the next 2 years, with annual RPI potentially seeing a peak as high as 4%. Assuming no further deterioration these effects will dissipate thereafter, but the impact on real disposable incomes for the period will be very real. Wages are very unlikely to keep pace with that kind of inflation, increasing at an annual rate of 2.2% currently. For those on a minimum wage, the recently announced rises were seen as a positive, but the value of the increase will be eroded in real terms given that the minimum wage is fixed (at £7.20) from next April. For pensioners there is some protection from the “triple-lock”, which guarantees that pensions rise by the higher of inflation, average earning or 2.5%; although the case for ending the triple lock may be more vociferously argued. Where pensioners suffer will be that, with a the commitment to a lower-for-longer interest rate policy, anyone who is relying on the interest paid on their savings will find that this money does not go far.
We will get some relief from currency related price effects by further international deflationary pressures. This seems a lot less likely than in recent years with OPEC and others seeking to stabilise the oil price, and even in China (the driver of much deflationary pressure) producer prices have turned positive for the first time in over four years. As for the US, where they have had the disinflationary benefit of a strong currency, inflation is nonetheless also picking up, pushing back above 1%.
Of course not all of this is bad. If inflation is running at a level above the level of interest that you pay on your debts, then the real value of that debt will be decreasing. As at the end of June people in the UK owed almost £1.5 trillion, nearly £55,000 per household, so a reduction in the real cost of servicing this would be very welcome. Unfortunately inflation remains below the rate of interest that people generally have to pay, and if it were to get close there must be a strong chance that interest rates would finally start rising. Once again we are back to the need for real wages to continue to increase in the way they have recently, and this seems unlikely.
If the MPC is determined to tolerate a pick-up in inflation without raising interest rates, is there anything that we can do to mitigate against rising inflation? Well, there are products that offer inflation protection. The most obvious of these are index-linked gilts, the coupon and repayment of which are linked to RPI. The problem is that they are very expensive. An issue that matures in 10 years time has a current real yield that is significantly negative (-1.9%). This means that inflation would have to average at a level of 2% for you to generate a positive. Clearly, if you think there is a risk of a return to the double-digit inflation of the late twentieth century there is a case for buying these, but monetary policy has moved on a long way since then and the risks, while worrying, would not seem that extreme. The other alternative is the governments National Savings and Investments inflation linked certificates, which pay an interest rate of 0.01% over inflation for either a 3 or 5 year period. However, they are only available to existing savers wishing to roll-over their investments and even then the amount is limited to £15,000. Many will argue that, historically, equities have provided a very good hedge against inflation and there is sound logic for this if companies are able to increase their prices in line with inflation and preserve profit margins. With equities yielding around 3.5% they would seem to offer pretty good protection against the worst forecasts for inflation, but these yields are not guaranteed and equities are, on most valuations, considerably overvalued.
As with many current uncertainties, the outlook for inflation would seem to be highly dependent on the outcome of Brexit negotiations. The current profile, while causing some erosion to real incomes, would appear to be manageable. What we don’t want is a return to high and variable inflation – there are many aspects of the seventies that we would not want a return to, but stagflation ranks well above union disputes and flared trousers.
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