By GRAHAM FROST 14/11/2007
At 2.1% annualised in October the Consumer Price Index was higher than the Bank of England target of 2% as the high oil price took its toll. The Retail Price Index, which is more important to the average person as it includes mortgage payments, was at 4.2%. Given that the Bank has warned that the disinflationary effect of China’s exports is waning, commodity prices have surged, employment remains robust, and credit expansion remains high, you might think that the next move in interest rates was up.
Think again. The Bank’s quarterly inflation report, released mid November suggests interest rates may fall by 50pts in 2008. The reason is that the turmoil due to the sub prime crisis is spilling over to credit markets. Borrowing costs have risen as banks have become more discriminate in their lending policies. In the US rates have already been cut by ¾%, despite inflation concerns, in order to avert a housing led recession. Bankers clearly believe that growth is slowing based on rate rises to date and are willing to take pre-emptive action.
Economists forecasts on CPI range from 1.5% to 3% by the third quarter next year. Clearly there is a range of views depending on what happens to commodity prices and the China effect, the value of sterling, and the depth of the slowdown. What should investors do? Government and corporate bond yields do not seem very attractive, although the recent sell off in credit markets has doubtless created some opportunities for more nimble strategic bond funds. Equities should be alright provided profits do not fall too much as they are tolerant of sub 3% inflation rates and like falling interest rates. Gold is a traditional inflation hedge but has already enjoyed a good run based on dollar weakness. Other commodities may also act as inflation hedges but again they have enjoyed a good run and would require a very positive view on emerging market demand. As we have seen with property, even the best inflation hedges suffer from periods of dramatic underperformance. A suitably diversified portfolio would seem as applicable as ever.