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Look! We’ve reached peak inflation

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Look! We’ve reached peak inflation
 

Another rise in the cost of living this week was not what families wanted to hear before Christmas, but inflation is set to peak at around its latest level of 3.1%, according to fund managers.

Bank of England governor Mark Carney will write the central bank's first open letter to the chancellor since February 2012, after November’s consumer price inflation figures breached 3% this week.

He will explain what the Bank is doing to bring inflation down towards its 2% target. The 0.1% rise to 3.1% during the month was mainly driven by higher transport prices.

‘Inflation continues to weigh on households as wages have not kept up with the recent rise, whilst savers have continued to suffer with low interest rates,’ said Adrian Lowcock, investment director at Architas.

Nevertheless, Lowcock suspects inflation could soon find itself on a downward trajectory.

‘Looking on the positive side the inflationary bump should start to work its way out of the figures and inflation looks close to its peak,’ he added.

Citywire A-rated Ben Edwards, manager of the BlackRock Sterling Strategic Bond fund, agrees. He expects inflation will move lower during 2018.

‘UK households may have to continue to endure higher costs in some segments over Christmas, particularly as food retailers continue to pass on higher producer prices and airfares take their normal seasonal trip north.

'But, with the pound finding relative stability over the past few months, this probably represents the peak in UK inflation and we expect headline prices to drift lower over 2018, all else equal,’ he explained.

Next year, he forecasts inflation will fall back towards its 2% target, which will cause the Bank of England to adopt a ‘wait-and-see’ approach to interest rates.

Distorting the figures

Citywire A-rated Mike Riddell, who manages the Allianz Gilt Yield and Allianz Strategic Bond funds, has urged investors to look beyond headline inflation figures. This is because base effects, which refer to year-on-year data comparisons, influence the figures.

‘Markets have consistently demonstrated an inability to understand base effects, as evidenced by reactions to high or low inflation prints that are entirely due to prior commodity price or currency moves.

'We therefore strongly suspect that the market is unprepared for the wage price growth that we should see being released in the UK from February,’ he said.

For example, the high inflation figures recorded in recent months reflect the impact of sterling’s fall following the UK’s European Union referendum last June. As this starts to drop out of the figures, he expects to see inflation falling.

‘Everyone is hysterical about UK inflation rising to 3%, but so much of this has been driven by sterling over the last 12 months,’ he said.

With this in mind, he warns that it is dangerous to extrapolate from year-on-year figures. Similarly, wage growth numbers will be affected by base effects early next year. Riddell points out that wage growth was negative in December 2016, so as this drops out of the year-on-year figures, it will cause wage growth to look relatively strong during the early months of 2018.

Investors may fixate on this and assume that a Bank of England interest rate hike is more likely and that the cost of borrowing may rise faster than they currently anticipate. This is not a scenario Riddell expects to see in reality, although he knows it will worry investors in bonds, which are expensive and tend to do poorly when interest rates rise,  and could also have a knock-on effect on share prices, which are less dear but quite fully valued.

‘We will see UK inflation starting to fall quickly through the first quarter, as big sterling moves downwards start to come out of the base effects. The underlying inflation rate will go down year-on-year, but wage growth figures will go up a lot.

‘Both of these effects will cancel each other out, but I think the wage growth numbers will probably dominate because markets are obsessed with wage growth numbers at the moment,’ Riddell explained.

# The debate over inflation came today as members of the Bank of England's monetary policy committee unamiously voted to hold interest rates at 0.5%. After last month's quarter of a percentage point rise - the first in over a decade - this decision was totally expected.

Unlike the US, where the Federal Reserve has just flagged its intention to raise interest rates three times next year, Philip Shaw of Investec Economics expected the MPC would lift UK interest rates by 0.25% just once, in the second quarter, followed by another quarter point hike in 2019. 

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