10/03/2011

By Philip Lawlor, Investment Strategist at Smith & Williamson Investment Management

Inflation is running at 4%, double the Bank of England’s target, and looks like it may increase further in the coming months. Whether it rises, falls or sticks at the current level will affect you and your business, so it’s important to understand what’s going on so you can adjust your plans to fit.

The debate over the direction of future inflation has left the Monetary Policy Committee divided into two camps — the hawks and the doves. The hawks believe UK inflation will become embedded and long-term — so are calling for interest rate rises. But the doves, led by governor Mervyn King, see the rise as temporary and forecast it to fall later this year.

King says the rise in the UK inflation rate over the past four years can be attributed to three factors. Firstly there has been a rise in import prices, which have risen by 20% over the past four years. This has been compounded by a weak pound, which has added 6% to the price level over the period. Secondly the rise in energy costs has also added 6% to price levels — since the start of 2007 the oil price has increased 110% and gas is up 130%. Finally, the two increases in VAT have distorted the Consumer Prices Index. Inflation excluding indirect taxes was 2.3% in January, well below the 4% headline figure.

Therefore ‘domestically generated’ inflation over this period, according to King, is close to zero. Doves argue that the current spike in inflation is temporary and, with the UK economy recovering from the deepest recession since the Second World War, it is too fragile to absorb an increase in interest rates.

The hawks claim that the UK economy has lost capacity permanently and that the output gap — the difference between actual and potential GDP (Gross Domestic Product) — is much narrower than previously assumed. They say that if this is the case, as the economy recovers, the increase in headline inflation will translate into rising inflationary expectations. Hence their belief in the need for an early increase in interest rates.

So, how you respond to and plan for future levels of inflation will be influenced, to some extent, by which of these two camps you think has got it right, and how this debate plays out over the next few months. Watch this space.

Philip Lawlor is investment strategist at Smith & Williamson Investment Management
philip.lawlor@smith.williamson.co.uk

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