Gilt investors will have “sat up sharply” at the news last week that inflation jumped to 2.7 per cent last month and the Bank of England had raised its inflation forecasts, observed Nicholas Hastings, a senior correspondent in London for Dow Jones Newswires.
“Continued consumer price gains will erode returns for these investors in what has been one of the world’s favourite safe-haven markets during the financial crisis,” said Hastings. “And, there is little that the UK Government can do about it. If anything, the UK authorities appear set on pursuing policies that will make matters worse and even further undermine the confidence of the once-supportive investment community.”
Hastings said that the problem with the rise in inflation was that it was not a reflection of a recovering economy.
The price rises came from one-off factors such as tuition fees and from higher food and energy prices, as well as an increase in core inflation. Forecasters are now looking for the rate of inflation to rise as far as 3 per cent in the coming months, right up at the upper edge of the Bank of England’s inflation target band.
As the Bank of England’s latest Inflation Report forecast, the rate will not fall back to its target of 2 per cent until the middle of 2014. In the meantime, the outlook for the economy continued to deteriorate, as the bank’s report also warned.
Even recent improvements in employment levels have proved unsustainable, with new data last Wednesday showing that the number of jobless claimants rose by over 10,000 last month rather than coming in at zero as expected.
With average earnings also rising by only 1.8 per cent, less than the market had been looking for, and with inflation well above that level, chances are that consumer activity will be hit as real earnings continue to suffer.
“But there is another key reason why the Bank of England isn’t likely to respond to higher inflation with tighter monetary policy,” argued Hastings, “the state of the UK mortgage market.”
Recent figures showed that over 50 per cent of mortgages in London and the south of the country are interest-only; mortgage holders are already fully stretched and not repaying capital. A rise in interest rates at this stage would put a further squeeze on household finances and push the economy even closer to a triple-dip recession.
“So, if anything, the UK Government is more keen to promote growth at this stage rather than tackle the inflationary pressures that could be building in the economy. But it can’t do so as obviously as it might like. And for sterling, this is where the problem lies.”
The Bank of England appears to have halted its regular doses of quantitative easing (QE) for now, said Hastings. Bank Governor Mervyn King said that although he has ruled out more bond buying for now, it had not lost faith in QE.
Nevertheless, in what some analysts have been describing as a ‘sleight of hand’, the UK Treasury announced last Friday that it was essentially appropriating GBP35bn of profit that the bank had made through its previous QE operations. King admitted that the move represents a “small” loosening of monetary conditions.
The Government could also be considering an easing of fiscal discipline. Until now, the Treasury has insisted that it will continue to pursue its fiscal targets in the Autumn Statement due to be made in early December. But there are reports that it might now slow the introduction of key reforms aimed at cutting welfare spending.
“The revision is being blamed on fears of a political backlash as the Coalition prepares for a general election in 2015. But the bottom line is that this will further ease fiscal constraints at a time when the economy is threatened with another recession,” said Hastings.
“For sterling investors who were already starting to get edgy about the UK’s failure to stage a more sustained economic recovery, this mix of high inflation and easier monetary as well as fiscal policy is hardly likely to make the pound, or gilts for that matter, any more attractive.”