Inflation is back – which domino will topple first?

Mark Carney © Getty Images
UK inflation is expected to take off later this year

Inflation in the UK is on the rise.

In January this year, it picked up to an annual rate of 1.8%. And what with the weak pound, it’s expected to get a lot higher later this year. Blame Brexit, or so the story goes.

There’s just one problem with that theory – this isn’t unique to Britain. Not by a long chalk.

Inflation is taking hold virtually everywhere – whether a country has voted to leave the European Union or not…

The deflationary scare is over – but when will inflation get scary?

Inflation is steadily creeping higher pretty much everywhere.

In Germany, inflation is rising at an annual rate of 2.2%, according to data released this week. That’s the sort of level that might pass without much comment in the UK, bar the odd snipe at Bank of England boss Mark Carney. But not so in inflation-phobic Germany.

A couple of months ago, German tabloid Bild led with an inflation story that spoke of the inflation “horror-kurve” – a wonderfully melodramatic expression which may one day be as widely used as schadenfreude has become today.

That’ll make life trickier for the European Central Bank (ECB), which may struggle to justify its ongoing money-printing programme. But something else will make life tricky for the ECB – it’s not even just Germany, with its strong economy, that has seen inflation pick up.

This week, we learned that eurozone-wide inflation is now above the European Central Bank’s professed target of “near but not at 2%”. In February, prices were up 2% year-on-year.

And there’s plenty more where that came from. Producer price inflation – the stuff that’s a bit further down the pipeline – rose by 3.5% year on year in January.

Now don’t get me wrong. Core inflation (which strips out fuel and food, volatile stuff like that) is still rising at just 0.9% a year. So the ECB can wield that as an excuse for keeping monetary policy as loose as it possibly can.

But it’s yet another headache on top of a volatile election year for ECB boss Mario Draghi.

Meanwhile in the US – where the economy and banking system are a lot healthier than in the eurozone – inflation is picking up fast too.

As with most other parts of the world, the US has various inflation measures. But one key measure – the Personal Consumption Expenditures price index, which the Federal Reserve is particularly fond of – hit 1.9% in January, just below the US central bank’s 2% target.

Fed boss Janet Yellen will be addressing markets later today. Assuming that the stockmarket doesn’t pause for breath, she’ll probably confirm that a rate rise later this month is very possible when the Fed meets on 14 and 15 March.

But regardless of what she does, the Fed is behind the curve. It’s always worth remembering this key fact: just because the Fed is raising interest rates, doesn’t mean that monetary policy is getting tighter. If inflation rises faster than interest rates, then in “real” terms, monetary policy is actually loosening.

As Kathleen Brooks of City Index puts it: “Even if a hike does happen, a third rate hike in ten years is not a sign that the Fed is taking away the punch bowl.”

Bad news for bonds – starting with the UK

So what’s next? Rising inflation will gradually put pressure on bond prices, as investors realise that higher inflation will eventually mean higher interest rates. That could be good news for equities in the first instance, as investors seek new opportunities as returns on bonds threaten to turn negative.

But it’s bad news for bonds. And as Marcus Ashworth points out on Bloomberg Gadfly, UK gilts look particularly vulnerable to a sudden change of mood.

The ten-year gilt currently yields around 1.2%. In the US, the equivalent debt – a ten-year Treasury – now yields around 2.4%. That’s a big gap. In fact, “British yields are at a record low relative to their American counterparts”.

The main reason for that disparity is that the Bank of England has been printing money to buy gilts ever since the post-Brexit panic. But that little burst of quantitative easing is set to end this month.

Meanwhile, notes Ashworth, index-linked gilts (which indicate the market’s expectations for inflation), are pointing to inflation of nearly 3%. “Negative real yields of minus 1.8% [on ten-year gilts] are hardly attractive.”

That suggests a big rebound in gilt yields could be just around the corner.

In the short term, that might not have an obvious impact on your portfolio. But if you’re considering remortgaging this year, you might want to look at doing it sooner rather than later.

Merryn

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