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A year of falling inflation

Inflation is rising. The Bank of England forecasts that the CPI inflation rate will hit 6 per cent in April, thanks largely to higher gas prices and to some price falls last January dropping out of the annual data.

The gilt market, however, is relaxed about this. Although five-year yields have risen significantly since last year’s lockdown, they are still only at the levels we saw in early 2019 when nobody was much worried about inflation. There’s a reason for this. It’s that inflation is likely to fall from the spring onwards.

Simple maths tells us this. From next spring onwards some price rises will drop out of the annual inflation data, such as petrol price hikes, the rise in VAT on hospitality and (eventually) higher gas prices. This will leave us with a higher price level, but a lower inflation rate.

And there are already signs of some price pressures easing. The price of Brent crude has dropped 8 per cent from its October highs, and those of copper, zinc and platinum have also fallen since then. One important lead indicator suggests these trends could continue. China’s money stock (on the M1 measure) has risen only 3 per cent in the last 12 months. In the past, this has led to weak growth in the country and hence to low demand for raw materials.

Another anti-inflationary force will be weak domestic demand. Higher gas prices, cuts to Universal Credit, higher national insurance contributions in April and an ongoing squeeze on public sector pay will all curb consumer spending. In that environment, retailers will struggle to raise prices much.

In fact, spending is already feeble: retail sales volumes in November were 2.8 per cent down on April’s level. People are not spending the cash piles they built up during the lockdowns. Having grown by 12.1 per cent in the year to March 2021, households’ bank deposits have risen a further 3.8 per cent since then. Yes, fast growth in the money stock can lead to inflation. But only if that money is spent – and so far this is not the case.

Nor is there much evidence yet of a wage-price spiral. Official figures show that in the year to November median monthly pay rose by 4.6 per cent – which is a fall in real terms. And for every sector that has seen a real-terms pay rise (such as transport, IT and finance) others have seen significant cuts, such as in manufacturing, retailing and construction. Except in a few industries, workers don’t have the bargaining power to push for inflationary pay rises.

Fundamental domestic economic forces therefore point to inflation receding later this year. This, however, is reason for only cautious optimism: a world in which gas supply is sensitive to Russian politics is not one which admits of great confidence.

But what if I’m wrong? Higher inflation than I expect is likely to be accompanied by weak demand – either because higher prices of gas or other key commodities squeeze real incomes, or because the Bank raises interests and thereby squeezes demand. In such a world, bond yields might not rise much simply because investors will seek a safe haven against the risk of falling share prices caused by earnings downgrades or increased risk aversion. The possibility of higher inflation might be a reason to avoid gilts, but it’s not a reason to switch into equities.