The spectre of inflation

As is my way, I look back at last month’s column, pull out all the bits that came good and discard the rest, managing, in the process, to convince you I got it right and hoping you can’t actually find last month’s article. I tried Google for a clever Latin phrase to insert here but it kept coming back with ‘all things change’ which is not what I was trying to say. I then stumbled on ‘in vino veritas’, took it at face value and the rest you can read below.

If you bought dollars for the first two weeks of the year, well done; if you held onto them, bad luck! Last month I focused on the idiosyncrasies of US CPI data and that you really can’t trust it as an empirical number. Did you know that one of the CPI components is calculated by asking people what they think they would have to pay in rent if they didn’t own the house they are living in?

I also mentioned that higher inflation was on the horizon. Perhaps I should have been looking at the UK when I made that statement. The UK consumer price index data came in up 1.0 per cent month on month in December, its highest ever one month jump, and up 3.7 per cent year on year, well above its target rate. The drivers for higher costs are blamed on surging oil and commodity prices, this is before the increases in value added tax (VAT – a sales tax added to most finished goods and fuel) came into play in January, as well as the added taxes imposed to try and trim the budgets.

One can only conclude that more inflation is on the way for the UK. The Bank of England is a little sanguine about this rise, betting that the increased costs will filter through to lower demand and ultimately slow the rate of inflation. It’s quite a gamble and also has quite a bit of lag involved as spending patterns don’t change overnight.

Unfortunately we have a tried and tested market reaction to higher inflation: the manual dictates that interest rates should rise and that with higher rates goes higher returns and this leads to buying of the currency. We have seen this all since the CPI numbers. What the market could be missing is that there is no political appetite for a rise in interest rates. You may argue (rightly) that this is not the remit of the Bank of England, but, and this is a Jay Lo sized one, if the BOE raised rates it would only add to the economic burden of the man in the street. It has been reported that more than two million borrowers in the UK have used a credit card to make mortgage payments in the year to August (2010). This is a staggering number. Pile on more sales tax, more income tax, higher commodities and then ask people to pay more on their loans and you can probably guess the outcome.

The BOE must be balancing all this data in holding off a rate rise, even if it’s using an obvious tactic of saying that demand, and therefore inflation, will naturally curtail itself just to buy time. It could work. Just do the opposite of what you should do with inflationary data!

The piper will have to be paid and I am more convinced that we will see a ‘hockey stick’ yield curve from those that defer dealing with the economics.