FTAdviser.com

Advertising

Global commodity prices are rising quickly and we are all seeing higher prices for food and energy products. In the UK the inflation rate jumped to 3 per cent in April and even the Bank of England said it would rise further this year. As a result, government bond yields have increased steadily since the end of February. Expectations in the money market of any further cut in the Bank's rate have been priced out. It looks like the UK is faced with soggy GDP growth, rising inflation and interest rates stuck at 5 per cent for some time.

The inflation targeting regime has served the UK economy well over the last decade. Today’s price level – as measured by the consumer price index – is lower than it would have been if the CPI had risen at a steady 2 per cent annual rate. Up until mid-2005, inflation was generally lower than target. This contributed to lower long-term interest rates and steady growth in the UK economy.

However, if we look at the Bank’s performance just over the last two years, the assessment is not so favourable. The actual price level is above the target price level. It is set to rise more quickly than the implied 2 per cent annual rate for some time. That means consumers will be paying more for a typical basket of goods and services than they would have been had the MPC been successful in meeting its inflation target.

This is not good news. The inflation we are seeing at the moment is largely generating upward pressure on commodity prices. For the Bank there are three options. One is to ignore inflation and cut interest rates anyway. The second is to sit tight and hope inflation goes away. The third is to raise interest rates and squeeze the economy to ensure the external inflation does not become embedded in higher costs and wages.

The second is the most likely and most market favourable outcome. The Bank is betting as the economy slows, inflation will come down. Rate cuts could resume later this year. But there is a lot of uncertainty and this will weigh on markets particularly if oil prices keep on rising. Only inflation-linked bonds provide any real protection should inflation not come down as expected. Other assets may have to adjust to a future where meeting the inflation target is going to be a lot harder.

Chris Iggo is senior UK strategist, Axa Investment Managers