19/01/10

By Andrew Holt

The UK inflation rate has come in at an annualised rate of 2.9% for the year to December, which is the fastest rate for nine months and well above consensus expectations of around 2.6% and compares to a figure of only 1.9% in November.

Most of the rise can be attributed to the anniversary of last year's cut in VAT and in addition there is evidence that retailers did not indulge in the heavy discounting of the previous year when the financial crisis was at its peak.

Next month, it is expected that inflation could rise to as high as 3.5% reflecting the re-imposition of the 17.5% rate of VAT.

Ted Scott, a director and head of stewardship at F&C, said: "This would necessitate a letter from the Governor of the Bank of England, Mervyn King, to explain why inflation has overshot the top end of its target range of 2-3%.

"It represents a considerable change over the last 12 months as a year ago the market was genuinely concerned about the threat of deflation as indicated by the government bonds at the time."

What does the poor inflation data mean for the markets and the economy?

Firstly, said Scott, it is important to point out that the sharp rise during December that will increase further in next month's report is mainly due to short term factors relating to the reduction of VAT towards the end of 2008.

"Nevertheless, excluding VAT there is evidence of incipient inflationary pressures: energy prices have been on an upward trend for some time reflecting the global economic recovery that is a lot more advanced than in the UK," he said.

Secondly, Scott noted, the lack of discounting by retailers suggests that they believe the worst is now behind them and this has been corroborated by the trading statements from the sector so far this year.

In the last couple of months bond yields have been advancing and recently the 10 year gilt breached 4% having only yielded 3.5% near the beginning of December.

The rise in yields reflects several factors but the increasing concern about incipient inflation is one of them.

The Bank of England has almost completed its quantitative easing (QE) programme of £200bn and recent comments by MPC suggest that it will not be extended.

This means that we may be nearer the inflexion point in the monetary policy cycle than had previously been expected and will soon be moving to a tightening phase.

"Today's inflation data has added to those fears that the first rise in official interest rates may come sooner rather than later, said Scott. "Some commentators have argued that a rise in rates is unlikely before 2012 but this now seems increasingly unlikely."

Another feature of economic markets so far this year has been the rally in sterling and the inflation data has led to further strength in the pound as the market anticipates an earlier rise in rates;sterling has risen by about 5% against the Euro in the last month.

Scott noted: "For the economy the earlier tightening of monetary policy is not good news.Ultimately monetary policy will be predicated on how the economy performs so if we have a double dip recession or growth is very subdued any rise in rates will be very gradual.

"In the short-term the rise in sterling will be an impediment for the export sector but more importantly it will raise the cost of borrowing for the consumer, even though the levels of borrowing in the private sector have come down since the MPC cut rates to 0.5%.

"Even a modest rise in rates could increase mortgage repayments considerably and make a meaningful economic recovery more difficult. It will also raise the cost of capital for the corporate sector but unlike some previous cycles companies are in reasonable financial shape."

For asset classes, the prospect of earlier monetary tightening is also generally negative, but much more for some classes than others.

Scott added: "Rising rates would be accompanied or preceded by rising bond yields for both corporates and gilts and, therefore, investors could face a large capital loss if yields did back up.

"Equities are a relatively good hedge against modestly rising inflation and I have believed for some time that investors should seek protection against rising prices by buying shares, especially those offering safe and attractive dividend yields"

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