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Falling inflation to keep rates low

Annual inflation slowed to a 14-month low in January, as last year’s VAT hike dropped out of the annual comparison and weak consumer demand relieved price pressures. This will help keep interest rates low and real rates, adjusted for inflation, negative.

Inflation’s declining trend to persist

The Consumer Price Index (CPI) declined for the fourth consecutive month to 3.6%, down from 4.2% in December and a peak of 5.2% in September, though still well above the Bank of England’s (BoE) 2% target.

Aggressive discounts in high street shops and lower fuel and utility prices had driven inflation down from 4.8% to 4.2% from November to December last year. January’s decline to 3.6% was in line with expectations, with the unwinding of last year’s VAT hike contributing significantly to the drop. Lower fuel-price inflation versus a year earlier also helped. As the chart below shows, if oil prices remain stable around today’s level, oil- price inflation will fall towards zero within the next few months.

We expect inflation to continue to trend steadily lower towards the 2.0% target by year end, on the back of falling utility prices amid weak economic growth. Still, this declining trend could be threatened if ongoing tensions in the Middle East were to lead to rising oil prices. According to the Office for National Statistics, the rise in crude oil prices accounted for almost the entire 0.5% rise in manufacturers’ input costs during January.

The BoE has argued for some time that significant overcapacity in the economy, following the 2007-09 credit crunch, is acting as a long-term disinflationary force. In the February Inflation Report, the BoE’s forecasts were revised up slightly, but with inflation continuing to fall during 2012 to below its 2% target by early next year. The central bank expects that weak economic growth, tightening credit and fiscal consolidation will weigh on spending, thus justifying its recent decision to engage in a further £50bn round of quantitative easing and leaving the door open for further asset purchases.

Rates near zero means real cash yields stay negative

With interest rates close to zero, a fallback in inflation will still leave real interest rates in negative territory, eroding the real value of cash savings. Indeed, 3-month sterling deposits have lost 7.7% in real terms, as measured by CPI, since the start of 2009.

Bond yields, which move inversely to prices, have historically tended to decline during periods of falling inflation and rise during periods of rising inflation. Falling inflation should thus support bonds.

We expect negative real returns on cash to persist in 2012, and see higher-yielding assets such as investment grade corporate bonds and equities with high dividend yields as attractive, as investors continue to search for yield. We also continue to see certain ‘real assets’, so called because they are physical as opposed to financial assets, as attractive amid persistent negative real-rates. As mentioned in our previous Daily Theme “Gold’s bright start to 2012, negative real returns undermine currencies as a store of value and drive investors to seek real assets not directly affected by inflation, depreciation, devaluation or default.

This was posted in Bdaily's Members' News section by Alan Higgins .