Inflation: has it peaked?

Tom Stevenson
Tom Stevenson
Fidelity Personal Investing14 November 2017

Has Mark Carney escaped the ultimate indignity? Will he avoid having to write a ‘mea culpa’ letter to the Chancellor?

The rules of the game for the independent Bank of England give the Old Lady freedom to set interest rates. But she isn’t out of the Government’s clutches entirely. If inflation rises to more than one percentage point above target, the governor of the Bank is obliged to write to the Chancellor of the Exchequer to explain what’s gone wrong.

With the Bank targeting a 2% inflation rate, that means a reading of 3.1% or worse triggers an explanatory missive. So today’s 3% announcement by the Office for National Statistics will have been greeted with some relief in Threadneedle Street.

Mr Carney has been given a month’s grace but many economists now wonder whether he might not have got away with it completely. There’s a real chance that inflation may have peaked this month at 3% and will fall away from here.

The main driver of prices rising at a five-year high today was an increase in the cost of food. That’s a direct consequence of the fall in the pound in the wake of last year’s EU referendum. But the nature of currency-driven inflation is that it tends to be self-correcting.

First, the comparable figures only look bad for a year. After that today’s cheap pound is compared with last year’s cheap pound and that means the inflationary impact of a depreciating currency is short-lived.

Second, if household earnings are not rising as fast as prices (we’ll find out tomorrow but it is almost certain that wages are rising more slowly than the inflation rate) then consumers will feel progressively poorer. And that inevitably feeds through into less consumption and, in time, weaker inflation.

So when people speculate that 3% might be the peak for inflation, there is a good chance they are right. The other drivers of inflation, such as an overheating jobs market, are simply not in evidence. Once the currency effect is out of the way, the underlying weakness in the UK economy will show up in the inflation data.

In light of this, it is not surprising that the pound fell again this morning. Sterling had already been in retreat since the weekend after a barrage of negative news for the UK Government had undermined investors’ enthusiasm for parking their money in British assets.

The Government looks increasingly weak following a run of Cabinet sackings and with speculation of a vote of no-confidence in the Prime Minister. This is all happening against a backdrop of stalled Brexit negotiations and the growing realisation that time may run out before a workable trade deal can be thrashed out with the rest of the EU.

With the pound still hovering above $1.30 this is not a sterling crisis like some we’ve seen in the past. Indeed, you could argue that the pound has held up remarkably well given all the uncertainty.

But the last couple of days have shown how vulnerable sterling is to continuing political chaos.

The other reason to expect the pound to drift further from here is the growing expectation that last month’s Bank of England rate hike may well prove to be ‘one and done’.

Mark Carney was keen to deliver on his forward guidance and so avoid a repetition of the ‘unreliable boyfriend’ tag that has haunted his tenure in the Governor’s chair. Reversing last year’s panicky quarter point cut in the base rate was, therefore, pretty much a given.

But if inflation does prove to have peaked today then there will be little pressure on the Bank to follow through with any more rate hikes for the foreseeable future.

What does that mean for consumers, savers and investors?

The nature of currency-related inflation running ahead of earnings is that the people hit by rising prices are the country’s poorest, for whom food is a bigger proportion of the weekly budget.

Many less well-off people will be desperate for a decline in inflation from here and will be wishing for a further easing of the public sector pay cap in next week’s Budget.

For savers, a falling away of inflation and an easing of the pressure on the Bank to raise rates further means deposits will continue to earn a pitiful return for now.

For investors, the message is clear. To generate a decent return, you need to move further up the risk spectrum into bonds and shares.

This will feel dangerous eight years into the post-crisis bull market, but sticking in cash really does guarantee a loss in real, inflation-adjusted terms.

The silver lining of the decline in sterling is the positive impact it has on the export-heavy FTSE 100 index. The UK’s main benchmark index nudged higher today.

If you think the outlook for the pound is poor, then a balanced portfolio of defensive UK blue-chips and overseas assets that will appreciate in sterling terms is probably the best bet.

A good starting point is the Select 50, our list of preferred funds.


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