Is inflation set to return to Britain?

Investors who think inflation is no longer a problem could be in for a nasty surprise.

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In Britain, now that consumer confidence and consumption have gathered pace, "the next thing that should come is the anticipation of pay rises", says Christine Johnson of Old Mutual Global Investors. Households haven't had a real wage rise for five years.

Generally rising demand is one thing, but the amount of supply in Western economies could also be smaller than central banks think. There has been much talk in recent years of the so-called output gap, also referred to as spare capacity in the economy. This is the gulf between an economy's potential and actual GDP.

In a recession this always grows, but the question is how quickly it disappears as recovery sets in and capacity that became idle in the downturn is used again.

The output gap is notoriously difficult to measure, and research suggests that after credit-bubble collapses, some capacity is rendered obsolete effectively permanently destroyed rather than merely temporarily idle. In that case, there is now less supply in the economy than central banks have assumed, so it will take less demand to stoke price rises.

In the early 1970s, the US Federal Reserve greatly overestimated spare capacity in America. It thus kept monetary policy too loose before the oil shock, worsening inflation. The unprecedented money-printing post-crisis is also likely to cause trouble. So far there has been scant inflationary impact, says Ben Lord on Bondvigilantes.com, because the printed cash has largely been hoarded by banks.

Once they start lending again in earnest, however, the money will move around the economy much faster. And it is the velocity of money, as well as the supply of money, that determines inflation.

Note too that central banks "have a nasty habit" of keeping monetary policy too loose for too long, as Bondvigilantes.com's Nicolo Carpaneda points out, so inflation could easily become entrenched. If any inflation surge can be capped at 4%-5%, stocks will cope, history suggests. Any higher than that, however as the 1970s showed and they won't.

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