Inflation wakes from sleep

Julian Chillingworth, CIO of Rathbone Unit Trust Management, takes a closer look at the implications of the latest inflation figures

Once again, nerves are being tested: this time on the inflation front. December’s UK consumer price inflation numbers (CPI) recorded a monthly jump of 1% to 2.9%. On the surface, there is no need to panic. These look mainly to be from the temporary impact of higher energy prices and the cut in VAT.

Turning East, as higher inflation proved a headwind for policymakers in 2008, it took a bit of a backseat last year. However, research suggests, (excluding China and the deflationary impact of Japan from this equation), inflation actually stabilised across most of East Asia to about 4%.

Winding forward to 2010, inflation is also climbing in China. Admittedly the sample is binary, tenuous even, but it does raise the question, is all-round inflation creeping up, having been a sleeping dog for some time?

Statistically speaking (the GDP numbers), we are out of recession in the UK. However, disappointing preliminary GDP numbers for the final quarter of last year suggest much slack in the economy. This seems to fit in with our central thesis that the road to recovery will be a bumpy one (even bumpier if there is a hung parliament), and the UK will be the last of the developed nations to raise interest rates.

Touch and go recovery

Even the weakness in sterling does not seem to be facilitating any major rebalancing of the economy. The UK is a ‘patient’ whose recovery is touch and go.

On the other side of the coin, there’s Asia. Granted that the inflation dynamics of Asia predispose it to blows from soft and hard commodities. However, the issue is whether this is now increasing faster than expected. So far, Asian central banks have opted for the softly-softly approach when it has come to monetary policy responses to the global slowdown.

Last month China and India manoeuvred their bank reserve ratios, limiting surplus cash in the banking system. In India’s case, inflation has been stoked by food price inflation; an inflation fundamental in Asia, which translates into increased numbers.

Likewise in China, where CPI leapt 1.9% in December after a 0.6% rise the   previous month, food prices appreciated significantly. This is anecdotal but crucial. As these and other developing countries urbanise, with subsequent income growth, the impact on commodity inflation will be profound. In other words, the inflation risk, and subsequent policy responses from the East, have the power to skew a global recovery.

This all leads to the major risk in 2010: central policy error. Any sway by the Bank of the England either side of this very tight rope could lead to either a strangulation of growth, or an inflationary surge in years to come. There is every chance that the degree of spare capacity, limited monetary growth and continued pressure on the consumer will keep inflation muted.

Machinations in the labour market remain important, but recent history suggests that upward pressure from wages is unlikely.

However, issues relating to UK sovereign debt and the potential to import inflation from the East (cost-push inflation) as time goes on might prove a tipping point. The imbalances facing the UK economy are not confined to these shores alone.