Forget deflation – inflation is still a far bigger risk for the UK

Last month, inflation hit its lowest level on record in the UK. We might even see deflation later this year.

Time to stock up on bonds then?

Not a bit of it.

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The reality is that conditions are ripe for an unexpected blast of inflation. Maybe more so now than they've been in a very long time.

Record-low inflation? Depends on how you look at it

Firstly, we learned that inflation hit a record low in January. Year-on-year, the consumer price index rose by just 0.3%. We might even see prices fall later in the year.

But this doesn't mean we're going to sink into a deflationary mire. So far, it's mainly petrol that's getting cheaper. As I've pointed out a few times, every £1 you save on petrol is £1 that gets spent elsewhere. And with crude oil prices rebounding very strongly, I'm not convinced this petrol effect will last for that much longer.

Meanwhile, core inflation (excluding all the volatile stuff) rose from 1.3% to 1.4%. And inflation measured by the retail prices index (the old measure we used to rely on, which is now steadily being written out of history) was well above its record low, at 1.1%.

So take any reports of record-low inflation' with a pinch of salt. It all depends on how you measure it. And as far as the prices that are actually falling goes, this is still very much good' deflation we're experiencing.

Then yesterday, we learned that wages rose at an annual rate of 2.4% in December. Excluding City bonuses, it was 1.6% but that's still a good bit higher than CPI inflation.

And this is likely to continue because the labour market is getting ever tighter. The unemployment rate dropped to 5.7%. The employment rate is at 73.2% the joint highest on record. "What's more," as Capital Economics notes, "employment growth is being driven by full-time employees."

People in Britain are getting jobs. Wages are going up ahead of inflation. The more people who get jobs, the more pressure there is on employers to push up wages. And the higher wages go, the more demand there is for goods and services. That pushes prices higher.

Not that the Bank of England is too worried about it yet. Certain members of the Monetary Policy Committee are still swithering over whether there might be a rate cut, rather than a rise this year. But if you're willing to ignore inflation caused by rising oil prices (as central bankers largely did in 2007), then you should be happy to do the same on the way down.

The bond market looks vulnerable

This lack of concern might not be a problem. Except for the fact that the one asset class that would be most badly hit by a pick-up in inflation debt is currently more expensive than at just about any time in recent history.

Government bonds across the world offer next to nothing or less than nothing in terms of income. There are plenty of reasons for this from investors using bonds as ways to play currency movements, to front-running quantitative easing programmes by central banks. But most of them boil down to speculation, rather than sensible investment decisions.

This matters. All other asset markets take their cue from developed world government bonds. If yields start to rise (and thus bond prices fall) due to fear of inflation or rising interest rates then other assets will also have to offer greater rewards to encourage investment. That usually means falling prices too.

And as a recent McKinsey report pointed out, the world remains hugely indebted. We haven't been deleveraging' far from it. We now owe more than ever.

You can argue that the eurozone offers a grim sort of check on all this. It looks like a deflationary blackhole. But even that might be an illusion. There are plenty of signs that the eurozone economy is actually passing the worst time heals most wounds, even economic ones.

If Greece turns out to be no more than a damp squib, and we've then got the European Central Bank pumping all the money it can into markets well, you might end up finding that things don't turn out as badly as everyone expects.

Ignore Greece for a moment and look at Germany. The stock market is at a record high and I've even read reports of Germans being encouraged to invest in property in a very British you can't lose with bricks and mortar' sort of way.

The point is, bubbles form when investors take a once-sensible view (the world will take a long time to recover from this credit bust) to an insane extreme (the world will never, ever recover from this credit bust and our entire store of innovative thinking and capacity for creative destruction has been used up).

We're over-pricing one outcome (rampant deflation) and under-pricing another (recovery accompanied by the inflationary erosion of debt). The problem is that when markets wake up to that, any rush out of bonds could get very messy indeed. You can read more about why we'd be avoiding gilts (and bonds in general) in this recent report.