Inflation falls – but a rate rise is even more likely

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Inflation fell last month. But interest rates are more likely to rise than ever.

In June, the consumer price index (CPI) annual inflation rate fell to 2.4% from 2.5% in May. Good news, you might have thought.

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But when you look more closely, the latest inflation data concealed some very bad news indeed

The fall in inflation, from 2.5% to 2.4%, was smaller than analysts had expected - the average forecast was 2.3%. Moreover, retail price inflation (generally accepted as a more accurate cost of living measure), actually rose, from 4.3% to 4.4%.

To be fair, RPI includes mortgage payments - so the recent rise in interest rates would have had some impact on this. But RPIX (RPI excluding mortgage payments) remained static, at 3.3%.

But most significantly - and most worrying for the Bank of England - was core' inflation. Core inflation excludes energy and food costs. Even though energy costs have been rising for some years now, the impact of higher oil prices is still regarded by many as short-term and volatile, as are food costs.

So if you want to get a clearer picture of underlying inflationary pressures - shops pushing through price hikes and the like - you strip out food and energy. This has been a nice little wheeze for anyone who thinks interest rates should be lowered, as if you strip out energy costs for the last few years, core inflation has been pretty well behaved.

But of course - and this is why we think its a nonsense to ignore energy prices - if energy costs remain high enough for long enough, that puts pressure on companies to raise prices to compensate. They may well swallow the added costs for as long as they can, but eventually they have to give in.

And if they feel that the economic environment is accommodating enough - such as when people have plenty of access to cheap debt and are willing to spend - they'll seek to raise prices all the sooner.

That's what's happening now. Core inflation in June actually rose to 2%, from 1.9% in May. That doesn't sound like much. But it's actually the highest level since March 1997, and above expectations. As Howard Archer at Global Insight said: "This suggests that retailers and companies are being successful in pushing through price increases."

The reaction of the foreign currency markets said it all. Yield-hungry traders, expecting another rate rise, sent the pound to its highest level against the dollar since 1981. This morning it's trading at more than $2.05.

David Brown of Bear Stearns warned that the news suggests that inflation will remain stuck above the Bank's 2% target. "We expect UK interest rates to rise to 6% before year end and it may not end there."

That won't be welcomed by UK homeowners - or estate agents for that matter. We fully expect another flurry of indignant press releases any time soon, pointing to falling headline inflation and completely ignoring any of the other, more negative figures. We don't know why they're so worried. After all, house prices can only ever go up.

Well, except in America.

Yes, the subprime calamity is still with us, despite the best attempts of all on Wall Street to pretend it's not actually happening. The Telegraph reports that Daniel Taylor, a US-based fixed-income manager at Aberdeen Asset Management told clients in London yesterday: "It feels pretty bad. As full awareness of some things that went on grows, markets are at risk of further contagion."

Contagion, by the way, just means bad news in one market spreading to another. We're never quite sure why the financial world feels the need to dress these things up in unnecessarily obscure language. Maybe it's because they know that if you explained it all in plain language, people would rapidly realise that it's not actually that complicated.

Of course, it's also a good way to make what are ultimately some very stupid ideas seem too boring and complicated for anyone to look at carefully. Say I decided to lend some money to someone who could never pay me back in a million years. Maybe I'd call that a subprime mortgage. Now, I don't want to be the mug who ends up not getting paid, so I'll sell another ninety-nine subprime mortgages and parcel them up into - let's call it a mortgage-backed security.

You go on packing these things up and passing them from one greater fool to another, give them a nice confusing name like collateralised debt obligations, and pretty soon, everyones forgotten that all of this rests on a ridiculous idea - that someone with no money can afford to buy a house.

Show a credit ratings agency the right calculations, and you might even be able to turn a pile of this toxic waste into AAA-rated, pure investment grade respectability. In effect, you've laundered your bad loan by taking it far enough from the scene of the original crime, and covering your tracks with alphabet soup.

But someone ends up holding this rubbish. And the first casualties look set to be investors in the two Bear Stearns hedge funds that brought this slow-burning disaster to light in the first place (for more on this, see: Subprime mortgage collapse: why Bear Stearns is just the start). We've just heard that the investment bank has told investors that there is "effectively no value left" in its High-Grade Structured Credit Strategies Enhanced Leverage Fund (the riskiest of the two), and "very little left" in the other one.

We'll have more on this tomorrow but as Sean Egan of US-based Egan-Jones Ratings tells Bloomberg: "This is a watershed. A leading player, which has honed a reputation as a sage investor in mortgage securities, has faltered. It begs the question of how other market participants have fared."

Not well, we suspect.

Turning to the wider markets

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In London, the blue-chip FTSE 100 index ended yesterday 38 points lower - at 6,659 - as inflation concerns weighed. Tate and Lyle was by far the day's best performer, gaining nearly 5% on positive broker comment, whilst an 'underperform' rating from Credit Suisse saw Schroders make some of the day's heaviest losses. For a full market report, see: London market close.

Elsewhere in Europe, the Paris CAC-40 fell 26 points to close at 6,099 and the Frankfurt DAX-30 lost 67 points to end the session at 8,038.

Across the Atlantic, stocks closed mixed. The Dow Jones topped the 14,000 mark in intra-day trading and achieved a fresh record close of 13,971, having gained 20 points overall. Strength in the semiconductor sector saw the tech-heavy Nasdaq end the session 15 points higher, at 2,712. But the S&P 500 was a fraction of a point lower, at 1,549.

In Asia, the Nikkei had fallen 201 points to 18,015 and the Hang Seng was 115 points lower at 22,941 this morning.

Crude oil had climbed to $74.23 today, whilst Brent spot had fallen to $78.24 in London.

Spot gold was last trading at $668.90 this morning, close to yesterday's five-week high of $669.05. (For a more in-depth gold market report, see our section on investing in gold. Silver had climbed to $13.00.

In the currency markets, the pound was last at $2.0514 against the dollar and 1.4871 against the euro, whilst a faltering dollar was at 0.7247 against the euro and 121.88 against the Japanese yen.

And in London this morning, shares in supermarket chain J Sainsbury were up by as much as 2.5% following a preliminary approach from Qatari investment fund Delta (Two) Ltd. The £10.6bn bid is the second this year for the retailer, following a failed buyout by CVC Capital Partners.

And our two recommended articles for today...

Why diamonds are for the long term

- You want have to wait forever to profit from diamonds, but expect slow and steady gains rather than a quick buck. For the best ways to gain exposure to the rising diamond price, read: Why diamonds are for the long term

Is there any way to save the Yen?

- Ben Bernanke once said he'd throw dollars from helicopters in the name of tackling deflation. J.M Keynes favoured burying bottles of money. And it seems the Japanese authorities' preferred strategy is to leave envelopes of cash in public conveniences. But in a true currency collapse, says Adrian Ash, you can't even give money away. For more from Adrian Ash on what the authorities can do to prevent the destruction of their currency's value, click here: Is there any way to save the Yen?