Bank losing credibility on inflation

Published on Thursday 19 August 2010 15:33

IN A week when Mervyn King had to write yet another letter to the Chancellor explaining why inflation is above the official target, it is understandable that questions are being asked.

Has the Bank of England lost the plot? For how long will household incomes be under pressure? Has the UK again become a high inflation economy, giving up the benefits gained with so much pain in the 1990s and 2000s? Is this the precursor to stagflation or the fabled double-dip recession that journalists love to talk about? Last but not least, can investors protect their savings from the ravages of inflation?

Has the Bank of England lost the plot? I do not think so. Indeed, I sympathise with its many problems. But, yes, I would agree that it has lost some credibility. This partly reflects factors outside its control, such as the major changes in VAT or commodity prices. However, detailed analysis of the Bank's economic models shows they have not been up to the task for some time, with poor growth and inflation forecasts.

As a forecaster, I recognise the difficulties when structural changes occur in any economy. The good news is that despite the public criticism there are few signs in the marketplace that too many questions are being asked about the Bank's credibility. Surveys of inflation expectations and measures of future inflation embedded into gilt markets both suggest that medium-term inflation is expected to be no more than 2-3 per cent a year

The bad news is that many households will suffer in this environment, well into 2012. High levels of unemployment mean limited wages growth for many; average earnings are only growing by 1-2 per cent a year. According to the Centre for Economics and Business Research, UK households' average available weekly cash will be 171 in September, a 4 per cent decline on last year.

At the same time, few savings accounts can beat current levels of inflation, hence the annoyance in many quarters when National Savings withdrew its popular index-linked certificates and cut rates on other products. This situation looks set to continue until the economic upturn becomes entrenched. Households will have to dip into savings in order to sustain high-street spending.

Indeed, this is an intended by-product of lower interest rates, to encourage people to spend rather than save. To that extent, policy can be said to be aimed in the right direction.

So is the UK becoming a high-inflation economy again? No, well not yet, is the answer. The recent inflation figures do need to be put into some context. While the CPI is running at just over 3 per cent a year, and looks set to remain so for most of the coming year, a large part is due to tax changes by past and present governments.

The CPI excluding indirect taxes only rose by 1.4 per cent in the year to July, and indeed has been in a 1-3 per cent per annum band since mid 2009. I prefer to say that the UK has become a more volatile inflation economy. While inflation up to 2007 was usually within the target band, since then it has usually been outside it. We should expect rather high or rather low inflation rates in coming years as the UK economy rebalances after the recent crisis.

It is worth examining inflation in some detail to see where these pressures lie precisely. Recently, the main contributors have been transport, not only petrol prices and air fares but also second-hand cars, insurance premiums on cars and homes, package holidays, telephone services and DIY materials. We should emphasise that while these areas, mainly services of one form or another, show rising prices, the consumer can still benefit from not only cheaper clothing and footwear but also some foods and beer, gas and electricity, and many audio-visual and computer-related items.

One of the key issues looking forward is whether food price inflation becomes noticeable.

Does this mean the UK faces stagflation, or could the inflation pressures even bring about a double-dip recession as households rebuild savings too quickly?

It is a risk, but the probability is low. The reason is less to do with inflation, more the strength of the corporate sector. We have to remember why recessions usually occur: that businesses find the gap between demand (low) and supply (high) too great and respond by cutting costs, especially their workforce but also factories, trade finance and so on.

Business is much better placed in 2010 than 2008, having built up sizeable amounts of spare cash. The survey of major Scottish businesses that was reported in The Scotsman last weekend showed a rather upbeat group of men and women.

Lastly, how can investors protect themselves in this environment? Not through holding cash, that is clear. At the recent Bank of England press conference, Mervyn King again emphasised that he prefers not to raise interest rates if at all possible while the economy faces the headwinds of tax increases and spending cuts.

Our view considers inflation will moderate in the years ahead, that its recent rise will be temporary rather than permanent. Nevertheless, investors should think about a mix of funds and assets in their portfolio: those that compensate better for inflation, such as certain equities, inflation-protected government bonds and some types of commercial property. There are no perfect solutions but a diversified portfolio containing those assets should do well over the coming few years.

• Andrew Milligan is head of global strategy at Standard Life Investments