Telegraph: Inflation is the big worry, forget deflation myth

by Dr. Ros Altmann

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Fundamentalist View, Saturday 11th April 2009.

When it comes to a rational analysis of the inflation myths that abound right now, it is hard to believe the apparent consensus among economists and many in the media because it is so wrong. We are not facing proper deflation – this is a convenient alibi for banks to force policymakers to ease policy. We should not be fighting deflation at all. In fact, as we know, the Consumer Price Index (cpi) is still above the Bank of England’s official target, even with the economy nose-diving. Producer price inflating is above 6%, pensioner inflation (according to the IFS) is also well above 6%, all kinds of prices are still rising, bank charges, insurance charges, transport, council tax.

I have not seen anything quite like this before. It amounts to hijacking of rational thought by banks’ self-interest. Deflation is a sustained period of falling prices. That is simply not on the cards.

Even if price pressures are lowered in a few months, that will merely be a temporary statistical base effect from sharp rises and oil costing more than $140 a barrell last year. The only things that are falling in price are interest rates on some mortgages and a few consumer durables or clothes. Food prices are bound to come down a bit in the summer too. But the main driver of the Retail Price Index (rpi) which is hovering around zero and will go negative perhaps next month – is lower mortgage rates; all mortgages are assumed to be on tracker rates in the rpi which is not, of course, the case in reality.

So we have many in the media, the Government and even the Bank of England talking about the necessity of bringing interest rates down to ludicrously low levels, because rpi has been depressed by ludicrously low interest rates. What nonsense.

I believe the political decision has already been taken to inflate our way out of our debts. Remarks by Mervyn King’, the Governor of the Bank of England the other week were really not so much expressing concerns about the budget deficit. They were more his way of saying “we can’t borrow our way out of debt, I am going to inflate our way out of it”. As money supply shoots up, sterling shoots down and interest rates stay on the floor, it is absolutely inevitable that we face a high inflation shock.

There is no way that the Bank of England could or would raise rates and rein in money supply fast enough to prevent this. Politically that would be impossible just as any recovery starts and the lags in the system are such that it would need to be tightening now, but it is still printing money for its ‘quantitative easing’. I call it ‘queasing’ because it is making feel so queasy about its consequences – and how this will hit savers.

Inflation will start to pick up either later this year, or in 2010. Wind forward a year. The VAT cut will be reversed – adding to inflation a bit. Interest rates cannot come down any more – even if they stay where they are that will mean inflation going up due to the base effect. Bank and insurance charges will keep rising as the financial sector struggles to build profit.

The bottom line to this ‘deflation’ nonsense is that we all know the Government can increase indirect taxes (including council tax, petrol tax, VAT, alcohol, tobacco and whole host of other charges) to engineer inflation if it needs to.

This all points to huge dangers for bond markets. The latest fad seems to be to buy corporate bond funds for a higher yield. If interest rates start rising – as they will have to and sharply – investors face significant losses on capital. Fixed interest gilts are in a bubble – and the unwinding of these artificially depressed gilt yields will cause mayhem in markets. Sterling will suffer again, corporate bond yields will also be adversely affected, although the spread may narrow because gilt yields rise by more than corporate yields rise, but that won’t stop investors losing money.

What one really needs now is as much inflation protection as possible. This will be in the form of index-linked gilts, which are still cheap and not discounting the coming inflation shock. It also means buying gold, in case the authorities lose control so much that investors take fright altogether and don’t trust any currency. The euro is too strong and needs to devalue but can’t; sterling is falling, the dollar is too high and needs to devalue to correct imbalances; Japan looks set to stay weak.

It is scary to see the authorities being hoodwinked by a non-existent deflation, while creating the next crisis in the form of inflation. And that will be a disaster again for pensioners. It may help pension funds for actuarial reasons, but people who are already trying to live on fixed incomes – particularly about 500,000 who are locking into an annuity this year – will be in desperate straits soon.