Peter Bickley: Best hedge your bets that inflation will remain an issue

But for investors who stocked up on them early, they have worked a treat. In October, the CPI eased back to a mere 5 per cent so for those lucky people the question has to be: what now? I go along with the Bank of England view that September was the peak in UK inflation and as we go into 2012 the monthly prints should fall rapidly back towards the 2 per cent target.

Inflation should disappear from the headlines and from investors’ consciousness. Index-linked might start to look less clever. With global growth having slowed and Libyan oil flowing once again, it is a reasonable bet that commodity prices should cease to be a driver of inflation.

With the major developed economies flat on their backs, it is hard to imagine domestically generated inflation gaining any traction at all. After recessions, output gaps are usually large, suggesting that significant recovery can be sustained without pressure on prices. Nothing, though, is ever as straightforward as it seems; inflation could come back to haunt us, even absent some geopolitical hiccup.

China’s contribution to deflation in manufactured goods (which by offsetting higher inflation in services helped our beloved Bank of England deliver on-target inflation for so long) is over. Chinese output prices are rising and will rise more rapidly as local inflation (and/or currency appreciation) has its effect.

The opportunities for manufacturing to roll on to the next source of cheap labour have not disappeared, but they are diminishing.

Output gaps are notoriously hard to measure other than retrospectively, but recessions do destroy capacity. Recessions combined with financial crises destroy most. It is tempting to assume that in an economy like the UK substantial spare capacity remains available for use but the survey data do not support that assumption; indeed they suggest the opposite.

Capacity in the form of plant and machinery has gone beyond reuse. A high unemployment rate may hide the fact that the pool of employable labour is actually small. It is reasonable to fear (and prudent to hedge) that the UK (or the US for that matter) economy could hit capacity constraints much sooner than many assume.

Then there’s the extended rounds of quantitative easing, another £75 billion in the UK’s case. Now it may be that when the time comes policymakers will (a) recognise it and (b) sterilise all that liquidity in some seamless way; the passage of a Gloucester Old Spot by the third floor window seems a tad more probable.

The payback from QE has been positive but muted; my hunch is that the UK’s latest bout will disappoint. It can hardly bring yields any lower and the primary impact appears to be to reduce velocity of circulation to a crawl. But come the day that activity and the financial system start to act more normally, when money velocity picks up, you do have to wonder where all that money will go.

It may be that the Bank will seek to mop it up through reselling all those gilts – in which case other holders should watch out. It feels more likely that having been bitten by stalled recovery so many times, policymakers will be reluctant to act too aggressively, leaving that money swirling around to do what excess money usually does. It may be that inflation will once again become more evident in asset rather than consumer prices; maybe, but would you bet the ranch?

This is a bit novel for me but I now see significant risk, taking together the confluence of a higher global inflationary backdrop, thinner than expected output gaps and plenty of excess money, that on a three- or four-year view genuine inflation – not the relative price changes bedevilling the data just now – may be an issue. I’d love to be wrong, but maybe you should hang on to those index-linkers. Maybe, perish the thought, you should buy a few more.

• Peter Bickley is a consultant economist