Playing with risk
Investors in fixed income assets should be scrutinising risks associated with a rise in inflation and consider these mitigating steps
Much has been written recently about the decline of the headline inflation rate in the UK. Indeed, from its peak of 5.2 per cent in September 2011, the current level of ‘just’ 2.4 per cent represents a significant fall. This is hardly surprising as several key influences on inflation have changed during the past 12 months. It should be noted, however, that the rate is still positive, and continues to be ahead of the Bank of England’s target.
The sharp increase – 34.8 per cent – in commodity prices seen during the six-month period from the fourth quarter 2010 to quarter one 2011 has subsequently reversed, falling nearly 22 per cent from its peak.
While it is clear that the weaker macro-environment is not supportive of commodity prices in the short term, the political will to foster a return to economic growth will undoubtedly create upwards pressure on commodity prices. This is likely to feed through into a higher inflation rate and is therefore supportive of inflation-linked protection within a portfolio of fixed income assets.
The velocity of money is at a multi-decade low. While global governments, through central banks, have been flooding the financial system with easy money, little of this has yet to reach the broader economy. This undoubtedly benefits the banks but, for a long-lasting solid return to economic growth, this liquidity needs to find its way into the hands of the consumer and businesses. This was highlighted recently with the announcement made by Sir Mervyn King, governor of the Bank, that up to £100bn would be made available to UK banks, under the funding for lending scheme.
Clearly Sir Mervyn wants to see the cash find its way into the broader economy. There is a very clear correlation between velocity of money and inflation. With a high expectation that money supply in the wider economy and the velocity of money will reverse their recent declines (quite simply, these are government objectives), it is likely that inflation will begin to rise.
The current indebtedness of many countries has to be addressed as a matter of urgency. The future value of debt outstanding is directly affected by both time, and critically, inflation. Clearly, an easy method for governments to reduce their debt burden is to allow inflation to increase. After a period of just 10 years at an inflation rate of 3 per cent, the future value of debt would stand at 75 per cent of the present value. It follows then that governments are unlikely to quell inflationary pressures in the near future.
Forecasting future inflation is particularly difficult as there are a large number of variables to take into account, it is however a key influence over central bank policy. On a quarterly basis the Bank of England forecasts future CPI rates within its inflation report.
Over a time span of seven years, the Bank of England has underestimated CPI on 90 per cent of occasions, and on average, by 1.1 per cent. With this long-term record in evidence, it is certainly possible that the Bank will maintain its extremely loose fiscal policy for longer than might be considered as prudent in terms of keeping a tight rein on inflation. Indeed, as evidenced by recent rhetoric from central bank governors, the threat of an increase in inflation is being accepted as a consequential by-product of the “defibrillation” of the global economy.
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