Join our community of smart investors
OPINION

Inflation to keep rates low

Inflation to keep rates low
November 21, 2014
Inflation to keep rates low

Although figures this week showed that consumer price inflation rose from 1.2 to 1.3 per cent last month, economists believe that was just a blip, caused in part by petrol prices falling less this October than last October. "The inflationary trend is downward" says Martin Beck of the EY Item Club.

Other figures this week confirmed that there’s no inflation in the pipeline. They showed that manufacturers' raw materials costs have fallen by 8.4 per cent in the past 12 months, and that their output prices have dropped by 0.7 per cent in the last six months. Manufacturing is already seeing deflation.

Economists suspect CPI inflation will fall below 1 per cent early next year, and that it will remain below 2 per cent until late 2016. This, says Mr Beck, makes it "unlikely" that the Bank will consider raising interest rates soon. Investec’s Victoria Clarke expects no rise until next August.

Many believe that ultra-low inflation will be merely the temporary effect of a strong pound and falling commodity prices, but David Owen at Jefferies urges investors to consider the risk that it could continue to undershoot expectations. This could happen for several reasons: if ECB quantitative easing forces sterling up; if oil prices continue falling; and/or if the recent pick-up in labour productivity continues, thus offsetting the rise in wage growth. And minutes of the latest MPC meeting show that the Bank thought it possible that low inflation could feed on itself by reducing inflation expectations.

In such a scenario, inflation targeting would require policy action to raise inflation. Although Oxford University’s Simon Wren-Lewis says this could in theory be achieved by a looser fiscal policy, few expect the government to do that. Instead, the onus would fall upon the Bank. One possibility would be to resume quantitative easing - although with gilt yields so low, this might not be as effective as it was in 2009. Another option would be forward guidance – a pledge to keep rates low for a long time. Mr Owen says: "The pattern of financial history is for interest rates following a banking crisis to stay a lot lower, for a lot longer than people imagine."