Don't Fall for the Deflation Hype, Beware Inflation Remains a Threat

By: MoneyWeek

So deflation's not all bad after all then.

The average commuter will see the price of a season ticket fall by around 0.4% next year, after the annual rate of retail price index inflation came in at -1.4% in July. It might not sound like much of a price cut, but it's a damn sight better than the 6% raise most had to pay out this year.

But train passengers should enjoy it while it lasts. Because it increasingly looks as though this is about as much of a whiff of 'deflation' as we're going to see in Britain...

Sticky inflation is not really a surprise

"We need to do everything we can to avoid deflation!" It's the war cry of central bankers across the world. And so far, the Bank of England under Mervyn King has actually achieved this goal rather well compared to its contemporaries.

Yet again, British inflation data surprised on the upside. Our inflation data does this so often - 12 times out of the past 16 months, according to the Financial Times - that the most surprising thing is that anyone gets surprised when the figures inevitably roll in above analysts' estimates. You wonder why they bother even guessing at the figures at all given how bad they are at it.

The annual rate of increase in the consumer price index (CPI) was expected to fall to 1.5% in July. Instead it remained at 1.8%, the same as June's reading. As for the retail price index (RPI), it fell at a slower annual rate of 1.4%, compared to the 1.6% year-on-year decline seen in June.

Why the disparity? That's straightforward. RPI includes home loan costs. So by cutting interest rates, the Bank of England actually drives RPI down. That's why CPI is used as the Bank's target measure of inflation – because unlike RPI, it doesn't rise or fall alongside interest rates.

Why Britain's been so good at avoiding deflation

A trickier question is why Britain is proving so successful at avoiding deflation. After all, in Europe, CPI is now falling at an annual rate of 0.7%, In the States, it's falling at a whopping 2.1% a year. What's the secret of the Bank of England's success?

Well, on the one hand, it's because Britain's economy is in such a terrible mess. Sterling took a beating against the dollar last year partly because international investors took fright at the sheer scale of our debts. That pushed up import costs for retailers and everyone else. The sorts of goods that rose in price year-on-year in June included computer games and toys, while furniture prices fell less rapidly than they did at the same time last year.

Meanwhile, interest rate cuts mean that consumers who still have jobs and also have home loans, have been left with a lot more disposable income than they had at this time last year. With a large number of shops also already wiped out by the credit crunch (think of all the holes in the high street that used to be Woolworths branches for example – no wonder DVD prices are up), retailers seem to be unconcerned about at least trying to pass higher prices on to customers.

So will this continue?

Plenty of people – most analysts in fact – reckon that inflation will, despite this stickiness, continue to decline over the next few months or even years. And there's a lot to recommend this point of view. There is little or no pressure on wages to rise. By some measures, there's a lot of spare capacity in the global economy, and that will continue to push prices downwards. And indeed, it's one reason why almost every other major economy is experiencing deflation.

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But this all comes back to why the Bank has been so successful at avoiding deflation so far. The argument among inflationists is that if a central bank really wants to avoid deflation and encourage inflation – and doesn't care about other consequences - then it can, simply by destroying its currency. But of course, currencies are a relative game. You might want your currency to be weak, but if your neighbour is pursuing those policies too, then it becomes a straight fight as to which of you is deemed less investment-worthy than the other.

The 'good' news – depending on your perspective – is that the Bank of England is in an almost uniquely strong position to trash sterling if it really feels it needs to. The dollar has plenty of problems, but it's backed by what is still by far the most powerful country in the world. The euro has its troubles too, but monetary policy there is effectively set for Germany, and Germany doesn't like the idea of inflation. Sterling isn't a commodity currency either – we have no great swathes of resources (anymore) to back the pound.

So of all the world's major central banks, the Bank of England is probably the one which has the easiest job of driving its currency down and creating inflation to order if necessary. And its actions earlier this month – in asking for permission to pump an extra £50bn into the economy – suggest that it intends to err on the side of inflation for the foreseeable future.

So while the pound may have strengthened yesterday as the inflation data suggested an early rise in interest rates could be on the cards, we doubt that'll happen. As one of our Roundtable experts points out in the current issue of MoneyWeek (Twelve stocks that will weather the storm, if you're not already a subscriber, claim your first three issues free here), there's a general election coming up, and the party in power wants to see the economy looking as healthy as possible by then. If that means propping it up on steroids and worrying about the inevitable collapse once the ballot papers have been counted, then so be it.

What this means for investing

What does this mean for you? Well, expect monetary policy to remain "accommodating", regardless of how frequently the inflation figures surprise on the upside. That suggests that – as we've been saying for a long time now – you should keep avoiding gilts. And it's an increasingly good idea to have exposure to non-sterling denominated assets outside the UK in your portfolio –we suggested a few US defensive stocks yesterday, while a few weeks ago in MoneyWeek we listed some of the 'emerging market' giants that are worth having exposure to. And of course, there's gold, the classic hedge against inflation or financial panic.

By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine .

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