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What will happen to inflation

15 November 2011 / by Oliver Roylance-Smith

With the spotlight well and truly on inflation, we take a look at the latest events that will have an impact on its future and consider what this might mean for savers.

Bank of England holds firm

The Bank of England’s Monetary Policy Committee (MPC) decided last week to hold the base rate at 0.5% and to hold quantitative easing (QE) at £275 billion. The last rate change was on 5th March 2009 when it was reduced from 1% to 0.5% and the latest £75 billion of QE was added last month, supported by a unanimous vote from MPC members.

Despite growing fears over the fate of the Eurozone, as well as domestic economic weakness, the decision to hold comes as no surprise. Since the additional £75 billion will take another three months to complete, it is expected that the Bank will wait until the first quarter of 2012 before even considering further action.

Economy in bad shape

The UK economic recovery is being restrained by weak business and household confidence. The headline rate of unemployment is also expected to see a big rise with figures to be released later this week - the number of 16 to 24 year olds out of work is expected to pass an unwelcome milestone by exceeding the one million mark for the first time since records began in 1992.

Two years ago the Bank predicted the economy would grow at 4% this year, a long way indeed off the current state of play and if the growth forecast is downward as expected, it will be the eighth reduction in succession. The latest data and survey evidence generally portrays an economy that is struggling to grow at all and the prognosis for next year is gloomy to say the least.

Recessionary fears grow stronger

Although the economy grew by 0.5% in the third quarter of the year, economic consensus is that the figure overstated the underlying strength of what is a stagnant economy.

Just three months ago, the Bank of England said the economy would grow by 1.5% this year. However, the Bank is expected to cut growth forecasts to 1% this week amid serious domestic and international headwinds. And the headwinds from the Eurozone are blowing harder than ever, thus significantly increasing fears of a double-dip recession.

More worrying signs ahead

The latest figures released today reveal that inflation as measured by the Consumer Price Index (CPI) reduced by 0.2% from their highest level ever to a current rate of 5%. Although in itself a positive change, the context already outlined is more worrying.

This time last year it was 3.1% and two years ago it was 1.1% which shows just how much the situation has changed. Even with today’s reduction, all but non-taxpayers still have to achieve a rate of 6.25% just to stand still.

What does this mean for inflation?

Speaking to the Treasury Select Committee at the end of last month, Sir Mervyn King, governor of the Bank of England, admitted that he was “not at all happy” with current inflation levels and that the further round of QE could easily add a further 0.5% to the already high rate of inflation.

He went on to say the real impact would not be clear for some time although reiterated his often-voiced expectation that inflation will drop off again in the next year. However, the Bank of England does not have the greatest track record of making inflationary forecasts so we should perhaps not read too much into this.

Calm before the storm

Although the governor no doubt feels obliged to balance the outlook with some optimism, this is not shared by all. Jupiter Income fund manager Tony Nutt believes that while inflation is likely to fall back in the short term, it will rise again over coming years.

Mr Nutt says: “Inflation will fall back in the final quarter of this year and the first quarter of 2012 but I am fearful of the years to come as the deleveraging process is going to take time to unwind. I think that inflation could reach 7% to 8% in the UK in the longer term.”

There is further support of the view that inflation will fall back before rising again and with the current domestic and economic backdrop, it would seem very difficult to argue strongly against it, despite the MPC’s valiant attempts to do so. Perhaps today’s softening of the headline rate and any short term reductions should rather be seen as the calm before the storm.

Act now…

The current picture is one of great uncertainty and it is difficult to feel confidence in the longer term impact of the measures being taken. Combined with continued low interest rates and high inflation, the immediate and, perhaps more importantly, the longer term impact must not be ignored.

Delaying taking action or losing sight of the real impact of inflation, especially over time, can produce painful results, not least for savers. Understanding the implication of low rates on fixed rate bonds, maximising Cash ISA allowances and giving full consideration to all of the alternatives available in the market are all sensible places to start.

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