Why the Bank of England is still too optimistic about inflation

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Anyone looking for a UK interest rate cut this year has had their hopes dashed.

The Bank of England is now predicting that UK consumer price inflation will remain in line with its 2% target in two years’ time.

But here’s the catch.

The Bank’s predictions assume that interest rates will follow the path currently expected by the money markets. And at the moment, the market expects that the Bank of England will hike rates by a quarter point before the end of this year.

So it looks like mortgage interest payments could be rising before Christmas rolls around again…

Even respected City consultancy Capital Economics has been forced to revise its bearish outlook for UK interest rates. The group had expected the key rate to fall as far as 4% this year, but now expects the Bank of England to keep the rate frozen at 4.5%.

But even though the latest inflation report has essentially crushed any hopes of a rate cut this year, is the Bank still being too optimistic?

“The inflation report describes a benign central view of steady growth with inflation remaining close to the target,” said governor Mervyn King.

That’s all very well. But as the Governor admits, the risks to that benign forecast “are many and varied. In particular, there are still risks on the downside associated with the impact of strong energy and import price inflation on real disposable incomes and consumer spending.”

In other words, high oil prices are still squeezing consumers’ pockets as rising energy bills and petrol prices bite deep. That’s likely to act as a drag on economic growth. But the problem is that the same high oil prices also drive up inflation, which makes it impossible for the Bank to cut interest rates to ease the consumers’ pain.

And the Bank is right to be worried about inflation. It doesn’t yet believe that “second-round effects” – like demands for higher wages – are being seen. But in April, a survey by the Bank showed that consumers have started to notice the squeeze on their earnings. Households now expect inflation to rise to 2.7% over the next 12 months – that’s the highest expectation on record.

And energy costs are also making companies wince. Greggs said that its profits in the year to date remain “materially below” last year’s. Underlying sales – that is, sales at stores open for longer than a year – were flat in the 18 weeks to May 6. Shares in the group fell 2% to £36.23.

The bakery chain, which sells more than one hundred million sausage rolls a year, managed to push through price hikes of 3% during 2005 – and it looks like there will be more to come. Companies can absorb the pain of added costs for so long, but if sales stay flat and costs continue to rise, the only way to improve profits is to raise prices. And that means higher inflation.

And of course, that other great indicator of inflation – the gold price – is screaming red. Gold broke through $700 an ounce recently, equivalent to more than £375 an ounce in sterling. As Brian Durrant of the Fleet Street Letter points out further down this email, the message you should take from the gold price is clear – ‘inflation is about to take off’.

The Bank still seems to be operating on the assumption that the current high price of oil is temporary. The trouble is, that’s exactly what it was thinking last year as well – and yet oil prices are now higher than at almost any point during 2005.

MoneyWeek economist James Ferguson wrote in last week’s issue that the price of crude oil could easily reach $90 a barrel by autumn. So if the Bank is hoping for a break anytime soon from the inflationary pressures of high oil prices, it could well be disappointed. MoneyWeek subscribers can read James’s story online here: How to profit from soaring oil prices

Turning to the stock markets…

The FTSE 100 ended down 22 points at 6,084. Electrical retail group DSG International was the main riser, climbing 7% to 207.75p as it said it would beat analysts’ profit forecasts after a better-than-hoped second half. Meanwhile, insurer Old Mutual was the main loser, down 3% to 193.25p as first quarter sales came in below City expectations. For a full market report, see: London market close

Over in continental Europe, the Paris Cac 40 fell 33 points to 5,278, while the German Dax fell 22 to close at 6,118.

Across the Atlantic, the Federal Reserve hiked the key interest rate to 5% and warned that further hikes could be necessary. The blue-chip Dow Jones gained 2 points to 11,642, while the S&P 500 fell 2 to 1,322. Meanwhile, the tech-heavy Nasdaq fell 17 to 2,320.

In Asian markets this morning, the Nikkei 225 lost 68 points to 16,883 as concerns about rising US interest rates continued to hurt export stocks. Nissan and Sony were among the main losers.

This morning, oil moved higher in New York, trading at around $72.60 a barrel. Brent crude was higher too, trading at around $72.50.

Meanwhile, spot gold hit a fresh 25-year high, rising to $712.50 an ounce before easing back to around $708. Silver was trading at around $14.44 an ounce.

And here in the UK, insurer Royal & Sun Alliance has beat City hopes for its first quarter. Operating profits came in at £207m compared to an average forecast of £194m, says Reuters.

And our two recommended articles for today…

Is the global economy really on the mend?
– ‘It seems like eternity since I was last optimistic on the world economy,’ says the famously bearish Morgan Stanley economist Stephen Roach. But now he believes the world has turned a corner and the outlook is brightening. So why the change of heart? And is he right to be upbeat? Or is the conversion of this most bearish of commentators a warning sign for the rest of us? The last time Roach was this bullish was in 1999 – just before the tech stock crash. Make up your own mind by clicking here: Is the global economy really on the mend?

Why soaring gold means rising interest rates
– US bond yields are up, global economic growth remains strong and the gold price is at record highs. It all points to one thing – inflation is about to take off. Central banks across the globe are reacting by cranking up interest rates – but the end of easy money spells disaster for several asset classes. To find out which investments will be worst affected, and which can help your portfolio weather the coming storm, see: Why soaring gold means rising interest rates


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