Inflation - where next?

While inflation is lower than the 21.9% we saw in 1980 and 10.9% in 1990, CPI remains well ahead of the Government’s 2% target and is around double the EU average. Which direction will it move next?.

Inflation data released today shows that prices rose by an average of 3% over the year to end of February 2010 (Consumer Price Index – CPI) or 3.7% if housing costs are also included (Retail Price Index – RPI).

While inflation is lower than the 21.9% we saw in 1980 and 10.9% in 1990, CPI remains well ahead of the Government’s 2% target and is around double the EU average.

Why does inflation matter?

It’s important because rising prices mean £1 will buy fewer goods and services in future than it can today. So the ‘purchasing power’ of earnings, savings and investments will fall unless they at least keep pace with inflation. Conversely, inflation is good news for borrowers; if prices double over the next 20 years then a £100,000 mortgage will effectively halve in ‘real’ terms to £50,000.

High inflation can also be bad news for an economy. It makes long-term corporate decisions, such as whether to build a new factory, harder which tends to reduce investment and slow economic growth.

What’s causing inflation?

The biggest contributor by far over the last year has been transport costs, largely driven by rising oil prices. Other contributors include tobacco and household goods, while the 1 January VAT rise has affected costs more or less across the board.

What might affect future inflation?

Oil price movements will likely continue to play a big role. A weak pound pushes up the price of imports, so currency movements could also make a big difference. On the other hand unemployment has been rising, so when the economy does pick up labour costs are less likely to rise (it’s harder to get a pay rise when there’s lots of competition for jobs).

Is my own inflation different?

Very likely, inflation figures are calculated using a notional ‘basket’ of goods and services and you’re unlikely to buy the same ones in the same proportion. For example, if you travel extensively you’ve probably been hit far harder by rising prices than someone who doesn’t. You can estimate how inflation affects you using the ONS personal inflation calculator ONS personal inflation calculator.

Perhaps the most interesting (and maybe worrying) thing at the moment is just how mixed views on where inflation will go next are.

What does the Bank of England say?

The Bank of England prediction seems to be CPI inflation of significantly above 2% in the ‘near term’, but eventually falling below 2% once the impact of the VAT rise and weak pound wane.

What the experts say

Fidelity Investments has gathered the opinions of several leading fund managers as follows:

Neil Woodford, Head of Investment at Invesco: "My view at the moment is we will see a pick-up in inflation. There are a number of factors that will automatically move inflation up in the early part of 2010. However, I believe the greater challenge is in medium term deflation. I think this inflation will subside and the underlying economy will not create the circumstances where that short-term blip in RPI will be reflected in structurally higher inflation in the economy."

Trevor Greetham, Director of Asset Allocation at Fidelity International: "The outlook for equities in 2010 is much better than we have seen in quite a few years. We have seen a pickup in global growth lead indicators coming at a time when there is quite substantial spare capacity in the economy. So any upturn in inflation ought to be fairly limited, policy should stay loose, and this combination of strengthening growth and loose policy means this is generally a good stage in the economy for stocks."

Richard Woolnough, Fund Manager at M&G: "In the short term there will be an inflation blip but in the long term we are very much in low deflation for a long time, but that's good deflation not bad deflation. As long as you believe free trade is going to be good, as long as you believe in technology improvements and competition, then over time it is a deflationary world, not an inflationary world. Compared to other bond fund managers we are quite relaxed about the inflation outlook, we do not think it is going to be a threat to bonds or to equities."

Hugh Young, Managing Director at Aberdeen Asset Management Asia: "Looking at Asia and emerging markets, central banks are starting to talk about the prospects of inflation. We have seen measures taken by Australia who were early off the blocks, bumping interest rates up to combat potential inflation. At the same time, we have got certain countries like Japan that are still in a deflationary mode. Things could go either way at the moment but I think we are more concerned about inflation rather than deflation."

Evy Hambro, Co-head of BlackRock Natural Resources Team and Fund Manager, BlackRock Gold & General fund: "A lot of it comes down to what governments are going to do with their fiscal plans, especially in the developed world. If governments resist temptation to bring these plans to an end early, my guess would be that inflation is going to be a greater threat than deflation. It really depends on what governments do with their plans that were designed to restart the global economy."

Conclusion

So the consensus, if there is one, seems to be higher inflation now but lower, or even negative inflation (deflation) in future. Deflation is no bad thing if it’s simply the result of companies increasing efficiency to cut costs (ignoring the moral issues of outsourcing to cheap third world labour), but if it’s due to prices falling in response to economic decline and us all spending too little it can become a big problem and stifle growth – Japan being a prime example.

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