Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
This article first appeared in the Telegraph
YOU may be reassured that inflation has eased back a smidge to 3.1%. Don’t be. It simply reflects the fact that restaurant prices are rising less quickly than they did a year ago at the end of the Eat Out scheme. The direction of travel remains upwards in the short term and it would not be surprising if next month the Consumer Price Index (CPI) number begins with a 4. No wonder Bank of England governor Andrew Bailey is talking about the ‘need to act’.
It’s easy to see why he feels the need to get on top of inflation. But that doesn’t mean he isn’t on the brink of a major policy blunder. It wouldn’t be the first time that a central bank had moved too far, too fast in a bid to burnish its inflation-fighting credentials. Europe over-reacted to an oil price spike ten years ago and the Fed was forced into a U-turn three years back after it was too quick out of the blocks.
The markets clearly think that the greater risk here is not too little, too late (which may still be the danger in the US) but an over-hasty tightening which forces the Bank to do a U-turn in due course. This is evident from the difference in the yields on short-term government debt (which are influenced by near-term interest rate expectations) and those on longer-term debt, which march to a different beat, building in expectations about growth and inflation further out.
In normal circumstances, the yields on bonds maturing further out are a bit higher than shorter-dated ones to compensate investors for the greater risk of loss due to inflation or default. If there’s a worry that a central bank is over-doing the tightening in the short-term, choking off recovery and crimping growth further out, then the reverse can be the case. The yields on longer-dated bonds can be no higher, or even fall below shorter-term ones. In the jargon, the yield curve gets flatter or inverts.
And that is where we find ourselves today in the wake of the Bank of England’s Damascene conversion from uber-dove, contemplating negative interest rates, to the world’s most hawkish major central bank. For the first time since the financial crisis, that yield curve is sloping downwards. Investors are effectively betting that the interest rate hikes they have priced in over the next year will prove unsustainable.
Another indication that the market is sceptical of the Bank’s ability to raise rates and keep them there is the pound. Again, this is on the face of it a bit of a puzzle. You would normally expect a currency to rise on speculation that interest rates are on the up. But that is only the case if the reason for the rate hikes is rising demand in a strong economy. Raising rates in the face of growth headwinds is likely to have the opposite impact. And it has. The pound is a lot weaker than you would expect given the yield gap between the UK and, for example, Europe.
The problem the Bank faces is that today’s inflation is supply, not demand, driven. Prices are rising because of higher energy prices and supply chain disruption. People are spending differently, less on holidays and eating out, more on buying things. But they are not necessarily spending more. And in future, as rising gas bills, higher mortgages, the end of furlough and reduced universal credit start to bite, they are likely to be even less inclined to spend.
This is why central bankers are sticking with the refrain that inflation is transitory. They risk looking out of touch by persisting with this line of argument, ignoring the lessons of the past - but they may well be right. They also know full well that raising rates may actually do little to counter the rise in prices. Central bank policy is well-suited to taming a demand-driven inflation surge but not one that’s fuelled by supply constraints.
As if all this wasn’t difficult enough, the Bank needs to consider the bind it has created by setting hard triggers for automatic changes to its bond-buying, or quantitative easing, programme. When interest rates rise to 0.5%, the Bank has said it will stop re-investing the proceeds of maturing gilts. And at 1% it has indicated that it will start selling bonds back to the market. There are a couple of dangers here. It could look strange that the Bank is tightening interest rate policy but still buying bonds. Or, maybe worse, it could find itself engaged in a heavy-handed double tightening, raising rates and at the same time shrinking its balance sheet.
This is all going to come to a head very soon because the Bank’s next rate-setting meeting is on 4 November. Not acting then could look indecisive, especially in light of last weekend’s comments from Andrew Bailey. Taking the plunge early could set us on a tightening path before we fully understand what the end of furlough and all the other growth headwinds really add up to.
And what does this all mean for investors? On the face of it, bonds look unattractive at the moment. In an inflationary environment of rising interest rates and yields, it is hard to make the case for investing in fixed income investments. But if the Bank does fall into a major policy error and growth hits the buffers, bonds could look a safer bet than shares.
The best thing the Bank can do is what Mr Bailey was trying to achieve at the weekend. Be really clear about its thinking and not to rush. And the best thing we can do as investors is to allow for the fact that there are many possible answers to the inflation question.
Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.
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