The Bank of England (BoE) should be commended on their efforts to to avoid the debt deflation trap. In the aftermath of the Lehman Brothers collapse, the 4.5% cumulative reduction in the BoE Bank rate and the £200bn quantitative easing programme were critical elements in stabilising the U.K. economy and generating the conditions necessary for inflation expectations to remain positive. That in turn resulted in credit creation and moderate positive economic activity. However, with such success come challenges, now in the form of persistently high inflation and what follows is a string of inevitable questions: Is U.K. inflation really going to get back to its target level of 2% or is the BoE overly optimistic given the degree of underlying price pressures? If so, should they do anything about it?
Since Lehman’s collapse in September 2008, U.K. headline consumer prices inflation has averaged 3%. Now that figure is 4.5% and looks set to climb higher in the months ahead. While much of the recent rise is due to the well documented combination of value added tax (VAT) hikes, sterling weakness and surge in commodity prices, even by the BoE’s own admission, the Consumer Price Index (CPI) is unlikely to get back to the 2% target by the first quarter of 2013, and it’s difficult to disagree with that sentiment.
Mervyn King, the governor of the BoE, has made his views clear: To generate the conditions necessary to bring inflation down more aggressively would put even greater pressure on U.K. households, more indeed than seems reasonable (see King, 25 January 2011, Speech at the Civic Centre, Newcastle). But that does not mean that investors should not be aware of where CPI is likely to settle down, especially for those investing in the U.K. financial markets and the bond market in particular. For example, ten-year gilt yields are currently at 3.3%, which means U.K. inflation really needs to fall back to the 2% level if investors expect to generate any sort of post inflation return. Sadly, that does not look likely.
To understand why U.K. CPI inflation will likely remain sticky we should look at past U.K. inflation drivers and ask whether these conditions remain in place for the future. Alongside the BoE, our own “top-down” models suggest that inflation should fall comfortably below 2% in the years ahead. Unfortunately, those same models suggest that outside of the VAT effect, CPI should already be below 2% rather than at the current inflation rate of 3% (Figure 1)!
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