While the Bank of England’s Monetary Policy Committee may be a long way from any sort of consensus on how to deal with high inflation in the UK, money managers are not only relatively sanguine about the threat of inflation over the medium term but share the view that interest rate hikes are not on the immediate horizon.
Rate Hikes Not on the Menu Du Jour
At a panel debate on “big bad inflation” hosted by Fidelity FundsNetwork this week, Jim Leaviss, head of fixed interest at M&G and manager of the M&G UK Inflation-Linked Corporate Bond Fund, Ian Spreadbury, manager of Fidelity International’s MoneyBuilder Income Fund and Strategic Bond Fund, and Azad Zangana, European Economist at Schroders, all reeled off reasons as to why the MPC can’t afford to hike rates just yet.
Even the most modest increase will have a catastrophic impact on household spending, Leaviss pointed out, highlighting that for a household with a tracker mortgage of 0.5%, even an interest rate rise of just 0.25% will inflate their monthly cost by 50%. Zangana agreed that he never gave any credence to market talk of a May rate rise, adding that the Bank of England needs to at least wait for the first quarter GDP result in April, the impact of rising National Insurance on spending, and the effect on inflation of the VAT increase wearing off before considering any changes. “We think August will be the first rate rise,” the Schroders economist said. Leaviss appeared even more bearish on a rate rise. Noting that Andrew Sentance’s departure from the MPC will moderate the divergence in committee member views, Leaviss said the Committee may feel the need for one rate rise for credibility sake but he believes it’s highly unlikely we’ll see anything substantial in 2011, with rates “on hold for the foreseeable future.”
Spreadbury sees scope for a few more changes over the next 12 months but said he’d be very surprised if the base rate was more than 1% higher than its current record low of 0.5% in a year’s time. Spreadbury did underline, however, the risk to the economy of such rate hikes. “We have a fundamental structural problem,” he said, adding that the UK economy’s debt—not just that of the government but of the private sector too—remains at unmanageable levels and until this is under control, the economy is not in a position to sustain economic growth going forward and so can’t afford rising interest rates.
Inflation Only a Long-Term Concern
None of the guest speakers were particularly concerned about UK inflation in the short or medium term. 2011 is bound to be an inflationary year, Leaviss said, what with VAT having risien to 20% and energy prices surging, but 2012 will probably be a year of lower inflation. Over the medium term, he’s relatively relaxed about the threat of inflation; it’s on a 30-year horizon, for example, that there’s more to worry about, Leaviss said.
The current high levels of inflation in the UK—levels that have caused Bank of England Governor Mervyn King to write 15 consecutive letters of explanation to two Chancellors of the Exchequer—have been fuelled by the tremendous rise in food inflation, energy prices, and the recent VAT rate hike, Zangana said. And it’s this VAT change that’s the key difference between UK inflation levels and the relatively lower levels of the US and Germany is VAT, therefore once the impact of this has fed through the economy, inflation should look less severe in the UK. Furthermore, the government’s spending cuts should eventually become deflationary as they reduce consumer demand, Zangana added.
The panel was in agreement that what we are currently experiencing is ‘cost-push’ inflation—fuelled by price increases that are out of our control, such as the oil price. It’s not this type of inflation that’s dangerous, they said, it’s ‘demand-pull’ inflation that we need to be concerned about.
Policies of Quantitative Easing have seen much of the developed world contend with interest rates close to zero for some time now. But while central banks have been printing money this money hasn’t gone anywhere, Leaviss said. At present, people are hoarding money and until this changes we won’t see the spark that is necessary to fuel demand-pull inflation. “If we see a spike in spending then that’s when we need to start worrying about inflation,” Leaviss said noting that this will trigger an increase in velocity and demand.
Noting that QE is an experimental policy and so we don’t know what the overall impact will be, Spreadbury pointed out that inflation can only really take off if people can afford to pay higher prices, but with wage increases muted this is not very likely at present, and with bank lending low people are still reducing borrowing rather than spending.
Asking a room of financial journalists how many are members of the National Union for Journalists, the results confirm Leaviss’ point that we are “not in a world where labour is powerful any more.” In the 1970s, workers backed by trade unions had the power to demand higher wages to offset inflation, but it’s a very different situation now. In a globalised world, people are only too well aware that striking is probably futile—if they strike here then labour will be provided from elsewhere.
Coping With the Long-Term Threat
So what does all this economic uncertainty, sustained low interest rates, and threat of rising inflation in the long term mean for investors?
Clearly the greatest damage done by high inflation is to those on fixed income, the savers and pensioners, Leaviss noted. But investors can respond to inflation, Zangana added: if inflation rises, investors can move their money into different assets that tend to perform well in inflationary environments—commodities, for example. Commodity price inflation, however, is not a linear relationship and thinking that investing in a commodity fund will ‘save’ you is risky in itself, Leaviss said, pointing to the peaks and troughs of oil price movements.
Having said this, the panel agreed that, though inflation may not be something to worry about in the immediate years, the key to preparing a portfolio for the long-term threat is to diversify. “This is the time to diversify,” Spreadbury concluded, noting the “huge uncertainty” in the economic environment. Leaviss pointed to the MPC as exemplifying this uncertainty; there’s a huge range of views on what the future holds and how to manage these outcomes, and these varying views come from the country’s top policy makers.
For now, it seems the talk of “inflation, inflation, inflation” is not an immediate concern. Indeed, Fidelity’s house view is that UK inflation will remain above 5% until the end of the year and will then drop off sharply as VAT comes out of the system. Long-term investors, however, could be positioning their portfolios across asset classes to accommodate economic uncertainty and inflationary threats.
Read Morningstar's views on effective inflation-hedging strategies in Inflation Protection is a Pick & Mix Deal.
